Do Changes in Interest Rates Affect Stocks?
Key Takeaways
Multiple reputable news sources have suggested that the recent market pullback is caused by the recent rise in bond yields.
More than half a century of data suggests that there is no discernible relationship between interest rates and stock returns. I.e. When rates drop or rise, stock returns have been both negative and positive (even when we consider longer term bond yields.)
It would be wise not to make changes based on short-term speculation.
One of the funny things about the stock market is that every time one person buys, another sells, both think they are astute.
If you had been following the news, it would appear that the recent weakness in the equity market has been blamed on the recent rise in bond yields (i.e. a fall in bond prices).
Treasury yields' wrecking-ball surge gets fresh fuel after blowout jobs report — Reuters
Yields Jump and Stocks Swing After Strong Jobs Report — NY Times
Dow Tanks To Lowest Level Since May: How Historically High Bond Yields Are Driving Slump — Forbes
Before jumping to this conclusion that rising bond yields are bad for stocks, like what the financial media has done — let us take a step back to examine whether that’s really the case. If it is indeed true, then this gives us information on how to act whenever this happens. If it is not, then we are faced with a decision to either ride it out or wait and see how things play out.
So, do stocks to react to changes in rates or yields? Let’s take a look at the fundamental factors that affect the prices of stocks.
The price of a company share depends on its shareholders’ equity — essentially the amount of cash remaining once a company's assets have been sold off and if existing liabilities were paid down with the sale proceeds.
The share price also depends on what cash flows an investor can expect from holding it and the discount rate applied on those expectations. The tricky bit here is that discount rates are indeed affected by interest rates; but while this is true, the expectations on future cash flows are independent from rates and really depends on the business of the company.
From a purely theoretical perspective, it is unclear what the net effect of interest rate changes on stock prices should be. And so, as always we turn to data and research for a clearer picture.
We take a look at a dataset spanning 60 years, comprising of monthly returns from the US stock market (which has the longest history), and comparing them to various changes in interest rates. The results are plotted below.
Stock returns are plotted along the Y-axis or vertical axis. You will notice that whether or not rates drop or rise, stock returns are both negative and positive. The datapoints scattered with no clear discernible pattern of positive or negative returns, as we move along the X-axis (the ranges of interest rates).
This randomness also persists even when you compare stock market returns with changes in longer term bond yields (shown below).
We can conclude from the data that even if we had uncanny prediction skills, and were able to tell in which direction yields were going to move — it would not help us in predicting stock market returns. There isn’t a discernible relationship or clear correlation between the two. As such, the learning lesson for investors here is that there is no reason to expect a particular direction of stock returns in the relation to changes in yield — despite what commentators are suggesting.
What is happening to the markets recently could be partly seasonal, and or could also be a result of other investors adjusting to how yields have settled at higher rates compared to recent times. Staying invested and not making changes based on short-term speculation increases the likelihood of capturing the returns that you are owed. It also reduces possible trading mistakes and transaction costs.
If you would like to find out what’s in store for portfolio returns in this higher inflation and higher rate environment, come and speak to us.
