Are Rising Rates a Threat?
The four most expensive words in investing are:
’This time it’s different’
Much to the surprise of investors, the stock market posted good returns for 2020 despite the overhang of COVID-19 and the ongoing economic malaise in quite a number of countries. Despite this, investors continued to buy bonds in record amounts in 2020, even up to early 2021.
Over the past few weeks, bond yields have risen sharply over a short period of time (bond prices have declined). Investors who bought bonds in the earlier part of the year may be staring at some losses should they choose to sell. Most investors know what happens to their bond investments when interest rates change — investors are incentivised to sell their bonds to purchase bonds with higher yields or investments with similar returns but lower risk. But what happens to stocks?
Commentary by investment strategists and CIOs of major financial institutions seem to suggest that rising rates are a threat to the stock market. But is it possible to predict these rising rates, utilising them to add returns to our investments? Research shows that changes in interest rates and bond prices are largely unpredictable (Fama 1976, Fama 1984, Fama and Bliss 1987, Campbell and Shiller 1991, and Duffee 2002), so trading on these predictions would not yield any success, but what about stocks? What could happen to stock prices when interest rates go up?
The truth is it could go either way. A stock’s price depends on both expected future cash flows to investors and the discount rate applied to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn causes the price of the stock to fall — this is what financial commentators are suggesting would happen. However, it is also possible that when interest rates increase, the expected future cash flow from holding a stock rises with it. This means that rising interest rates can affect stocks both upwards and downwards. If theory doesn’t give us an indication of what the overall effect would be, what can data tell us?
Research done by Dimensional Fund Advisors examined the correlation between monthly US stock returns and changes in interest rates. This is shown in the chart below.
The data shows that when interest rates rose, stock returns were as low as −15.56% and as high as 14.27%. In months when rates fell, returns ranged from −22.41% to 16.52%. So, do rising rates affect stock prices? Yes and no. According to the data, stocks declined only 40% of the time when rates rose. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was about the same when you examine all months, and not just those in which rates went up. Thus, there is no clear link between stock returns and interest rate changes.
In summary, there’s no conclusive evidence that anyone is able to reliably predict changes in interest rates. Even with perfect knowledge, this information provides little guidance about subsequent stock returns. Instead of listening to unverified financial opinions, stay invested and avoid the temptation to make changes based on short-term predictions. There are far better things to think about than worrying about changes in interest rates.
