The Effect Interest Rates Can Have On Equity Sectors, Indices, And Commodities

Summary

• After reaching almost 180 basis points [bps] (1.80%) in March of this year, the 10-year Treasury yield is now hovering around 118 bps.
• Because of the volatility surrounding interest rates over the past 18 months, I wanted to conduct a sensitivity study between the 10-year yield and different sectors, indices, and commodities.
• Currently, with a high correlation between stocks and bonds relative to history, bonds in totality might not represent a good hedge for systematic equity risk.

Nikolay Pandev/E+ via Getty Images

Why I Conducted This Analysis

From quantitative easing during COVID to inflationary fears following an economic reopening, interest rate volatility over the past 18 months has been astronomical in my opinion. At the start of 2020 the 10-year treasury yield was 192 bps, at the low of COVID the yield touched 33 bps, in late March this year the yield got to 177 bps, and now currently sits around 118 bps.

Source: TradingView

Historically stocks and bonds have typically held a negative correlation to each other. In a booming economy stocks may perform well, rates may rise, and bonds prices may fall or underperform stocks because they move inversely to interest rates. This inverse nature can also prove to be advantageous if you hold bonds during a stock market correction because they can provide a safety net if rates are forced down quickly through possible quantitative easing efforts by the Federal Reserve. Currently, this historical trend is not holding true. Below shows a correlation graph comparing the S&P 500 and 10-year Treasury futures:

Source: Bloomberg

Because the current correlation between stocks and bonds is high relative to history, interest rates could severely impair both equity and debt markets if they were to suddenly rise.

Inherently debt markets are going to have an effect on equities and other asset classes. The reasoning for this surrounds the fact that interest rates can help explain liquidity and inflation conditions which may directly impact the performance of stocks and commodities. It is important to note that interest rates may not always be a perfect indicator for generalizing the economy as rates can be artificially manipulated by the Federal Reserve through quantitative easing [QE] policies. Because interest rates play such an important role in all markets, I wanted to conduct a sensitivity analysis between equity sectors, indices, and certain commodities relative to the 10-year Treasury yield.

Test and Results

To conduct this test I first downloaded monthly returns for all 11 Global Industry Classification Standard [GICS] equity sectors [(VPU), (VDC), (VCR), (VNQ), (VDE), (VAW), (VHT), (VIS), (VOX), (VGT), (VFH)], the 4 major U.S. stock indices [(SPY), (QQQ), (DIA), (IWM)], 2 commodities [(GLD) and WTI Oil], and the monthly moves for the 10-year Treasury yield dating back to September 2004. The monthly correlation results between all the sectors, indices, and commodities with the 10-year Treasury yield are shown below from highest to lowest correlation: (Note: the correlation is comparing the sectors, indices, and commodities to the 10-year Treasury yield, NOT the 10-year Treasury bond prices, that's why the Bloomberg chart shows a mostly negative correlation between the S&P 500 and the 10-year Treasury futures and the results below show a positive correlation between the S&P 500 and 10-year Treasury yields.)

Source: Created By Author Using Data From Koyfin

Next, I wanted to show the sum of monthly returns since September 2004 for each sector, index, and commodity I analyzed during positive and negative moves for the 10-year yield in a given month: (Note: because I simply summed the returns, there will be returns <-100%.)

Source: Created By Author Using Data From Koyfin

Use of Study

How I View the Data

Predicting macro-economic trends is an extremely difficult task as even the best forecasters in the world are consistently unable to predict what will happen with the economy, including interest rates. Instead of using this data as a way to speculate, I personally view it more as a way to attempt hedging an equity portfolio in the midst of highly correlated equity and debt markets (relative to history).

Example #1

If you were an investor holding a portfolio of utility companies, you may be concerned if rates were to rise. According to my study, utilities were the only negatively correlated equity sector to the 10-year rate. I believe the reasoning mostly has to do with their leverage (increased rates may increase their WACC), their dividend premium over Treasury Notes declining as rates increase, and the fact interest rates may disrupt the ability for multiple expansion. Based on the data in my study, you could hedge utility's interest rate exposure with an oil or energy position because the energy sector has the highest correlation to the 10-year Treasury yield.

Example #2

For those who may be looking to speculate on inflation and interest rates, I wanted to throw in a possible example for use. Below you will see a chart comparing China PMI output prices to the U.S. CPI index:

Source: Bloomberg

According to the chart, U.S. CPI and China PMI have been visually correlated for the past 4.5 years. With China PMI recently falling from over 56.0 to 51.1, one may assume U.S. CPI will follow suit and decline in YoY growth %. Investors may assume that if inflation is truly transitory like the Federal Reserve keeps saying, they will be less inclined to hike rates, keeping Treasury yields suppressed or pushing them lower. With that prediction, someone may look at my sensitivity analysis and choose Real Estate (VNQ), Utilities (VPU), and Gold (GLD) to invest in as they have the lowest correlations to the 10-year Treasury yield.

Example #3

This one is more for fun but if you look at a chart of global real interest rates dating back to 1317 A.D., you will see rates consistently have declined over the course of history:

Source: Rutgers University

Some investors may believe this trend will continue into the future and that U.S. 10-year Treasury yields would follow suit. With that being the case they may choose to overweight sectors, commodities, and indices with the lowest correlation to interest rates for the very long term.

Risks

One reason the study may be imperfect in explaining the sensitivity of sectors, indices, and commodities to interest rates is because there are other factors influencing stock and commodity prices. Back to the utility-energy example, let's say you were holding a portfolio of utilities (VPU) and energy (VDE), and rates were to rise at the same time oil prices were falling due to external factors. There is a chance the use of energy as a hedge against rising rates affecting utilities wouldn't perform as expected because of other factors impacting the sector.

Conclusion

With a lot of financial market chatter surrounding inflation, QE tapering, and now the delta variant, interest rates will be impacted and play an important role in many investment decisions. The data shown above could be a useful place to start if one is looking to hedge specific sectors or commodities against possible rate moves. I hope the readers find this interesting and if anyone has questions I'd be more than happy to answer in the comments.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of VDE, VFH, VGT, VIS, VOX, VPU either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This analysis is not a guarantee of future results, models and projections are based on inputs that are likely to exclude all factors that may reflect a complete analysis. Furthermore, calculation errors, inaccurate reporting, and unseen inputs could bias results. For financial advice please consult with your advisor or other professional. This commentary reflects the personal opinions, viewpoints and analyses of the Alpha Squared Capital, LLC’s employees providing such comments, and should not be regarded as a description of advisory services provided by Alpha Squared Capital, LLC or performance returns of any Alpha Squared Capital, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this article constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Alpha Squared Capital, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Alpha Squared Capital, LLC provides links for your convenience to websites produced by other providers or industry-related material. Alpha Squared Capital, LLC is not responsible for errors or omissions in the material on third-party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third-party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.

Comments

[Banneker]

Thank you for researching and producing these data. Great food for thought.

[Ben Howard]

@Banneker Appreciate it!