Higher Interest Rates are Bad for Stock Markets

By: Steve Swanson

The following is an excerpt from Steve Swanson's Market Turning Point Trading

It is a basic investment tenet that investors seek to earn the highest rate of return for the lowest possible risk.  Generally, higher risk opportunities provide better rates of return and vice versa.

Some of the best historical returns for investors have been earned by owning stocks.  The annualized return for the S&P 500 Index (and its predecessor S&P 90 Index) between 1926 and 2012 has been about 10.08%.  But stock markets also carry the higher risk of possibly losing your principle investment too.  Less risky bank CD’s or government Treasuries carry almost no risk of losing principle because they are guaranteed by the government.  With that guarantee however, comes a much smaller rate of return.

It is at this juncture where the struggle over asset allocation really begins.

Interest rates as defined by the Fed Funds Rate dictate what banks, corporations, and ultimately consumers pay to borrow money.  For corporations, their borrowing rate affects their ability to maintain inventory, expand operations, invest in new products, or even buyout competitors.  For consumers, it determines how much they will have to pay for mortgages, new cars, home improvements, education, etc.

As a result, higher rates generally lead to less corporate and consumer borrowing and spending activity, while lower rates increase spending.  Ultimately, the question of importance is this: What is considered a high rate, and what would be considered a low rate?

A high rate is one that increases the cost of borrowing beyond what the purchaser considers “reasonable”.  Their sense of reasonable is usually based on comparing current rates to the recent past.

When higher finance charges are added on top of a higher cost to produce products, rising costs soon approach uncomfortably high levels where buyers may refuse to purchase financed goods.  Sales of major appliances, autos, and homes turn downward.  When buyers balk, seller inventories rise and they are forced to offer incentives like discounted prices to move those goods.

It soon becomes a game of dominos.  Discounted inventory lowers earnings and affects future profit expectations.  Shareholders, unhappy with lowered valuations and smaller dividends, may choose to sell shares which then drives down stock prices.

Interest rates can have an even more direct impact on stock markets.  When guaranteed investments such as US Treasuries offer yields only slightly lower than current stock market returns, professional money will begin to flow out of the markets and into Treasuries.

Treasuries are promissory notes the US government issues to finance its debt.  Those bonds carry a guaranteed interest rate, and if held to maturity, also guarantee the principle too.  Stock markets provide no such guarantees.  Stock prices fluctuate daily and the potential for losing principle is real.

Smart money concedes; why take a greater risk in the market when you can earn nearly the same return elsewhere without the risk?

When interest rates are low, the yield earned on Treasuries is low too.  In 2014, that rate was less than two percent on a 10-year note.  Smart money stays in the markets when the average annual return is 10 percent or greater.  But, rising interest rates will change all of that.

Stock markets are likely to be near their highs when interest rates start moving up.  By the time rates reach five percent or higher, professional investors are already well into funneling dollars into Treasuries.  At that point their strategy is to protect the principle and lock in a guarantee rate of growth, even if it’s temporarily less than earnings in the stock markets.

Retail investors on the other hand, are slow to recognize a market top forming, and less likely to understand the impact of interest rates on market prices.  When inflated markets begin to implode as money continues to flow out of the markets, investors may panic but are likely to hold on to positions until losses become so painful they finally sell – somewhere near the bottom of the decline.

This is why a key consideration for the investor is always this: Where are interest rates right now, what direction are they moving, and when will they trigger a market reversal?