Don't overrate rates: the relationship between interest rates and stocks

Amongst investors, there is widespread belief that stocks move with interest rates. Allegedly, high and rising rates are bad for stock market returns, whilst low and falling rates are good. But is this true? When Fisher Investments Australia reviews the historical record, we find it isn’t useful perspective for investors.

The underlying premise appears sensible enough: share prices are supposed to reflect the present value of future earnings, as business schools and finance classes have taught for ages. Their textbooks are filled with formulas – such as discounted cash flow and weighted average cost of capital calculations – using prevailing interest rates to estimate what those future earnings are worth today.

Since interest rates represent the time value of money – the benefit of having a dollar now versus later – the lower they are, the less opportunity cost there is from receiving cash now instead of waiting (and vice versa). That is, when interest rates rise, there is more opportunity for cash to earn a higher return now than receiving it in the future, which makes far-distant cash flows (e.g., earnings) less valuable today. So higher rates should weigh on shares via this theoretical fundamental connection.

But in the real world, there is no evidence the relationship holds. The valuation theories Fisher Investments Australia reviews often don’t work out in practice. Consider the evidence from America’s century-long market history of US stock returns and government bond rates, as measured by the S&P 500 and 10-year Treasury yields, respectively.

Yes, there are stretches when stocks fell as bond yields rose. See the start of the Great Depression: from June 1931 to January 1932, yields spiked 1.1 percentage points to 4.3% as stocks cratered -44.8%.[i] And other times, stocks climbed whilst yields slid, like in the early 1990s: from April 1990’s 9.0% yield to September 1993’s 5.4%, the S&P 500 gained 54.8%.[ii]

But there are also periods when both fell at the same time and rose in tandem. From January 2000 to May 2003, Treasury yields slipped from 6.7% to 3.4% – and US stocks dropped -27.5%.[iii] America’s post-pandemic recovery saw yields nearly triple from July 2020’s 0.6% to December 2021’s 1.5% and the S&P 500 soar 48.8%.[iv]

If high and rising rates usually sink stocks – and low and falling rates reliably boost them – then they should have a strong negative correlation, based on Fisher Investments Australia’s reviews of such popular claims. In statistical terms, a -1.00 correlation means a perfectly inverse relationship whilst 1.00 shows they move in lockstep. A 0.00 reading would indicate no relationship. Over the US series’ entire history, the correlation is -0.02 – effectively zero.[v] There is no lasting relationship. A statistician would say rates have no explanatory power in gauging stocks’ direction.

What about Australian stocks and rates? There isn’t a strong correlation here, either. At -0.12, stocks and rates Down Under have a wee bit more tendency to move opposingly, but that remains functionally meaningless.[vi]

In our experience, interest rates’ equity market implications are limited. As Fisher Investments Australia’s reviews of investment myths find, investors possess a unique edge when knowing something that is true which most others can’t fathom. If headlines holler rising rates will shock stocks, you can challenge that thinking and use historical data to avoid reacting to the fearful news – a way to maintain discipline, which is an essential ingredient in successful long-term investing.

Fisher Investments Australia thinks this is bullish! Take, for example, Australian 10-year yields’ rise from a record low 0.8% in March 2020 to their 4.9% October 2023 peak.[vii] It came with warnings all along the way: ‘when interest rates go up, stocks go down’ went the refrain. Here is how one article put it in November 2021 as rates rose to more than two-year highs: “already, the surge in bond yields has sent the ASX lower as investors look on warily at the prospect of rising interest rates.”[viii]

Or another in May 2022: “changes in interest rates can impact companies and equity market performance in several ways. As interest rates rise, debt servicing costs increase and squeeze profits. Valuations, especially for growth sectors like technology, can be battered by a jump in rates. Finally, higher rates curb inflation by slowing the economy, an important source of profit for companies.”[ix]

Now, sentiment can swing stocks short term for any or no reason. But for the almost four-year stretch when rates rose more than four percentage points? The MSCI Australia returned 54.9%.[x] Oh, and Australian Tech’s 102.8% nearly doubled that.[xi] Fisher Investments Australia suggests keeping your head, whilst others lose theirs, can help you beat the crowd.