On Rates and Stock Prices

February 26, 2013

Longer term, a key question for investors is how the stock market might react to higher interest rates.
-David Kelly, chief global strategist, J.P. Morgan Funds


In the week ahead, investors will be focused on early numbers on the pace of economic activity in February and whether Congress and the President will avoid inflicting the “Sequester” on the long-suffering public whom they serve.  However, longer-term, a more important issue is what will happen to financial markets as interest rates rise.


With regard to this week, the FHFA Home Price Index, Case-Shiller Housing Price Index, and New Home Sales on Tuesday, and the Pending Home Sales Index on Wednesday should all confirm a strong and steady improvement in the housing market. Similarly, final University of Michigan Consumer Sentiment and Conference Board Confidence could point to an improvement in sentiment among consumers for February after January’s “payroll-tax-induced” fall in both indices.


Durable Goods Orders may reverse the gains made in December on Wednesday on a sharp decline in Boeing orders. Light Vehicle Sales due out on Friday should keep pace with January’s numbers, while still pointing to a steady improvement in the cyclical sectors. For the Manufacturing sector, after mixed signals from the Empire State and Philly Fed Manufacturing survey’s, the Chicago PMI on Thursday and the Markit and ISM PMI’s on Friday should all indicate further expansion, albeit at a slower pace than in January. Additionally, after a few volatile weeks due to weather and seasonality issues, Jobless Claims seem to be back at their prior trend, signaling a moderately healing labor market.


This week will also see the release of the BEA’s second estimate of Real Q4 GDP on Thursday and Personal Income and Outlays for January on Friday.  After a disappointing advanced estimate, real GDP growth should be revised to a small positive number, in light of stronger than anticipated trade and final sales data.  Personal Income will most likely fall sharply in “pay back” for December’s accelerated bonuses and special dividend payments. Likewise, Consumer Spending should be dampened in January, as households adjust their budgets to higher tax rates.     


The Sequester does seem likely to take effect on March 1st.  However, while it stands as testament to the dysfunctional nature of our political system, it still looks likely that its worst impacts could be mitigated in the months ahead, allowing the U.S. economy to stay on a growth path.


Longer term, a key question for investors is how the stock market might react to higher interest rates.


In addressing this, it first must be recognized that the pace of increases in both short-term and long-term interest rates remains highly debatable.  With regard to short-term interest rates, the Federal Reserve reaffirmed at its January meeting that it intends to keep the federal funds rate in its current zero to 25 basis point range until the unemployment rate falls to 6.5%, provided inflation and inflation expectations remain contained.  Given the current subdued pace of economic growth this may well not happen until late 2014 or 2015.


With regard to long-term interest rates, the story is more complicated as the Fed does not have absolute control over long-term rates.  So far, 10-year Treasury yields have backed up from less than 1.5% at their low last summer to about 2.0% today.   In the long run, 10-year yields average about 2.5% above inflation and with inflation currently running at 2.0%, a “fair value” for the 10-year Treasury could be at about 4.5%.  Rates could move very slowly to this level if economic growth remains sluggish and the Federal Reserve continues to expand its balance sheet.  However, Fed officials appear to have growing reservations about the asset purchase program, as was clearly reflected in the minutes of the January FOMC meeting. 


To be blunt, the pace at which long-term interest rates could rise remains highly uncertain.  However, assuming that they do rise, what does this mean for the stock market?


In traditional economic theory, the answer is clear and it is negative for two reasons.  First, the intrinsic value of any asset is the discounted value of the cash flows that that asset can be expected to produce either in the form of income or of capital gains.  If long-term interest rates rise, then so does the discount rate applied to those cash flows.  Because of this, higher long-term interest rates should reduce the value of stocks.  Second, rising interest rates could hurt economic growth and thereby profits.  This would obviously be a negative for stocks.


However, in today’s environment, the answer is much more murky.