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Bill Poulos: Increasing Interest Rates Are Bad For The Stock Market… Right? Wrong? Well It Depends.

Summary

There is a correlation between the rise and fall of interest rates and the stock market.

Historically, as interest rates rise the stock market follows.

Historically, if interest rates fall the stock market also falls.

During the 2008 recession, the Federal Reserve initiated an interest rate easing program. New interest rate policies will play a factor in what happens to the stock market.

As the stock market continues to climb, unabated week after week after week with 2017 putting in a record year in terms of the number of new weekly highs without even a 10% correction, much of the dialogue now is around the potential negative impact on the market as the Fed cautiously raises interest rates.  The fear is, of course, that rising interest rates will lead to a fall in stock prices, ostensibly because then treasury bills, notes and bonds and other debt instruments will be more attractive than they are now and draw money out of the stock market and into these debt instruments. 

So is this a valid concern? Well let's go back in history and look at the data. Since World War II up until 2008 2009 there has been a strong correlation between interest rates and the stock market’s performance. As interest rates go up stocks go up as interest rates go down stocks go down. This may be counterintuitive at first but that's what the data shows. (Living since 1947, investing since 1974, and becoming a financial educator in 2001, I've witnessed many of these financial changes firsthand.)

Now why is that? Well we used to have what was called the economic cycle where the economy would go from expansion, peeking out and then enter a contractionary phase, referred to as a recession.  The recession would tend to act as a catharsis, clearing out the excesses in the economy that built up during the expansion, which then set the stage for the next expansion. But what was going on with interest rates in that cycle?  Well when the economy was in recession the Federal Reserve would typically reduce interest rates in an effort to stimulate economic growth and once they started reducing rates they would continue to do so month after month after month until the economic data showed that the contraction or recession was ending and that a new expansion was beginning. So as the rates dropped throughout the recessionary period,  did the stock market. In fact the stock market typically would peak out and begin to drop prior to the official economic data indicating that a recession was underway. 

Now as the recession came to an end and economic growth reasserted itself the Fed would begin, after a while, to slowly raise interest rates and as the economy became stronger and stronger in terms of quarterly growth the Fed would raise rates more and more.  Why? - to act as a brake on the economy, so that it didn't get overheated and cause undesirable inflation.  Now while the economy is growing and the Fed is increasing interest rates, the stock market is going up as well in anticipation of stronger and stronger corporate earnings.  

So when rates went down the market went down when rates went up the market went up.  That was the pattern with a high degree of correlation from World War II through 2008. Then everything changed when the Federal Reserve took unprecedented action to effectively drive interest rates to zero through the massive buyback of US treasuries through the quantitative easing program, buying billions of dollars in treasury bills for eight to nine years unabated.  This had the effect of keeping interest rates near zero regardless of economic growth or lack thereof. Now, to be sure, the economic growth since 2008 has been very moderate to say the least, seldom exceeding 3% year-over-year, but at least the economy was not in recession. 

But in spite of lackluster economic growth, stock market boomed, supported by the unprecedented near zero interest-rate policy of the federal reserve along with the central banks from most other developed nations following suit. The correlation between interest rates and the stock market no longer applied during this. primarily because of the artificial intervention into the free market by the Federal Reserve.   And so with  moderate economic growth, we had a booming stock market, a market that is accustomed to seeing rising interest rates in an expansionary economy . But this time around it is almost giddy about the Fed zero interest rate policy. What could be better? economy expanding and interest rates remain pegged to zero. 

All the while this has been happening, there has been a general unease in the land as the US national debt has more than doubled since quantitative easing was initiated. Now north of 100% of GDP. While this debt load has not negatively impacted markets as of yet, no one really knows the endgame except that it's highly unlikely this debt will ever be repaid or even curtailed given the propensity of Washington to continue to spend money they don't have. 

So there's been a disruption in the Force called Federal Reserve quantitative easing and not only the US Federal Reserve but the other central banks of the developed countries around the world basically doing the same thing. You could view that disruption, the unprecedented printing of money never before seen by developed countries, as having fueled the current bull market instead of fundamentals. 

Now the Fed has shifted gears and is slowly unwinding the balance sheet and slowly, very slowly increasing interest rates. Trying to build rates back to a level that would allow the Fed to have ammunition to combat the next recession by reducing rates  once again to stimulate the economy. I believe the Fed is trying to get back to some sense of normalcy, but it's a very difficult process to accomplish that without prematurely upending the economy. And furthermore, as interest rates increase, the federal government service on the $20 trillion debt goes up significantly which ends up adding to the annual deficit of the government which causes the national debt to continue to accelerate.  So the Fed in my opinion, can only raise rates so much before they cause the federal government to have to borrow even more money to pay the higher interest - clearly an untenable situation. 

Circling back, the correlation between interest rates and equity prices that prevailed for over 60 years came to a screeching halt with the advent of quantitative easing and now we are in uncharted waters concerning how any further interest rate increases will impact the stock market. But since years of zero interest rates have had the effect of stimulating the economy and the stock market more directly it's reasonable to assume that if the Fed pushes rates up too rapidly, the market will indeed peek out and experience a correction of significance. 

The market will probably do that anyway, regardless of what the Fed does, if for no other reason due to the extended unprecedented bull market that at some point will come down for any number of reasons.  And when it does we are probably looking at least a 30 to 60% drop.  This is not a wild assumption. This is what happens at the end of bull markets and this is what happened in 08, this is what happened in 2000, this is what happened in 1987, although briefly, it happened in 1974 and it will happen again.  But this time around, interest-rate policy will only be one of many factors that could bring about the end of the bull market.

Disclaimer: These thoughts are my own and no one is paying me to write them. I regularly invest in options, stocks, and currencies. There is always risk in investing money. Before investing, consult your licensed financial planner.