Dispelling Interest Rate Myths

Includes: DIA, QQQ, SPY
by: Erik McCurdy

You have probably heard the following arguments many times before as they are made often by financial market analysts. The first contention is that "falling interest rates are always supportive of stock prices," and the second is that "recessions are always preceded by an inverted yield curve." As with all such myths perpetuated by conventional wisdom, there is a measure of truth in both. The problem, in both cases, is with the use of the "always" qualifier. Simply replace "always" with "often" and both statements become valid, but the question then becomes: when do these axioms fail?

The Japanese stock market has been in a secular bear market for about 20 years, and during that time the Japanese economy has been dominated by deflationary pressures driven by a persistent decline in aggregate demand. The policy response, as expected, has been to keep interest rates at very low levels for a very long time, and it is in this macro environment that our two assertions break down. The following graph from Hussman Funds displays the correlation between Japanese bond yields and stock prices since 1975.

Prior to the start of the deflationary secular bear market in 1990, the "falling interest rates are always supportive of stock prices" rule worked just fine. Afterwards, however, just the opposite took place as falling interest rates were then accompanied by falling stock prices. The "recessions are always preceded by an inverted yield curve" rule also failed as shown on the next graph.

Prior to 1990, recessions were usually predicted by a yield curve inversion, but none of the subsequent periods of economic contraction have been.

Of course, the Japanese experience during the past 20 years is the most recent example of the required deflationary environment, but there are many others, including the Great Depression in the US during the 1930s and 1940s. During that time period, stock prices experienced long, cyclical declines in low interest rate environments and the yield curve failed to predict any of the recessions following the stock market crash in 1929.

So what about right here, right now in the US? We are certainly experiencing an extended period of artificially low interest rates as the Federal Reserve attempts to spur economic growth, but have we also entered a deflationary environment driven by a structural decline in aggregate demand? The Consumer Metrics Institute (CMI) believes the aggregate demand shift is underway, and the persistent weakness in their Growth Index since late 2007 supports their position.

There probably hasn't been two separate recessions in three years, simply one that has evolved in significant ways. But if this really is a 'double dip' recession, then our data indicates that the 'Great Recession' of 2008 was merely the precursor, and not the main event. It is this current dip that we should be really concerned about; the current contraction in consumer demand is about structural changes in consumer behavior, whereas the 'first dip' was about short term loss of consumer confidence. This recession has been complex and constantly evolving in ways that policy makers have not been able to understand through their low resolution lenses. As a consequence their policy responses have been misguided, ineffective and wasteful. The Federal Reserve may be able to save the banking system by being the 'lender of last resort,' but it is powerless to change perhaps the one thing that John Maynard Keynes got right -- and what he mischaracterized as a 'Paradox of Thrift' -- as over 100 million U.S. households become economic 'loose cannons,' acting exclusively in their own best interests in 100 million different ways.


If we assume, for the moment, that the CMI is correct, then the last piece of the puzzle would be price deflation itself, and the median CPI component price change data tracked by the Federal Reserve of Cleveland is currently sitting at long-term lows.

Federal Reserve research has demonstrated that this metric is one of the most accurate forecasters of inflation trends, and right now it is signaling that deflationary pressure is at its highest level in more than 50 years, so we may indeed be in a period during which the "falling interest rates are always supportive of stock prices" and "recessions are always preceded by an inverted yield curve" myths are once again exposed as such. As always, time will tell.

Disclosure: No positions