This is the relationship between interest rates and stock returns

In the conventional literature there is a tendency to extend the idea that rate hikes are negative for stocks and rate cuts are positive.

The basic premise is that higher interest rates lead to higher borrowing costs for companieswhich implies lower profit margins and, consequently, a reduction in business profits.

All of this should negatively affect the valuation of the company and, finally, in your quote. But is it really so? Is there really a clear cause-effect?

The following chart from JP Morgan gives us an idea about what happens when interest rates start to rise.

On the one hand, we have the X-axis showing us the 10-year US bond yield, and the Y-axis showing the 24-month rolling correlation between weekly S&P 500 returns and changes in US bond yields. In this point two periods are distinguished.

From 1965 to January 2009: Stocks and interest rates move together until ten-year US bond yields rise to 4.5% and then move in opposite directions.

From February 2009 to today: Stocks and rates move together until the yield on debt reaches 3.6% and then they move in opposite directions.

The distinction between before the great financial crisis and after is interesting. The correlations of the previous decades, when stock returns and interest rate movements tended to be strongly inversely related.

About 75% of monthly correlation observations from 1970 to the start of the global financial crisis were negative, compared to less than 14% from that time to the present. While many variables likely contributed to this disconnect, the absolute level of interest rates may be the most important factor.

Let’s put ourselves in the mind of the investor. Ten-year US bond yields rising from a 2% level simply don’t have the same competitive return appeal as if they were trading at 8% – why be public if the safe asset offers a high return? The threshold effect is found at a debt return of 6%. At that time, the stock market tends to be discriminated against in favor of acquiring debt.

More than a decade of extremely low interest rates

Although it is difficult to precisely quantify the impact, the low rate environment of the past decade has clearly been beneficial to share prices.

In this period, investors tend to avoid conservative assets like bonds and turn to stocks. The equity risk premium. In addition, stock price valuations, calculated as expected future cash flows of companies discounted to the present using a discount factor based on the risk-free interest rate, benefit.

When we look at low rates, the denominators in those present value calculations are also low, leading to higher valuations.

So even though interest rates have risen for several periods in the last decade, share prices continued to rise sharplyas rates remained extremely low in absolute and historical terms.

Moreover, the rise in interest rates from low levels reflects a booming economy which is what helps stocks rise. At some point, there may be a turning point where the business cycle continues to move forward. This comes about when rising rates eventually slow the economy back into recession and then stocks fall.

Another point is that the positive correlations accumulate from 1999 to the present. The rate increase did not reflect a weak economy, but a strong economy. Stocks benefited. When the Federal Reserve cut interest rates, it reflected a weak economy. Stocks fell during those periods.

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