As the US economy has finally recovered from its post-GFC malaise, so have US interest rates risen from historical lows. This is a natural progression; policy makers keep interest rates low while economies are weak – in order to stimulate borrowing and investment, and raise interest rates as economies strengthen, in order to slow inflation and stop economies from overheating.
The rally of interest rates off historical lows has been a boon for stock markets. The US 10-year treasury yield has grown from a target of 0 – 0.25% in December 2015, to a target of 2.00 – 2.25% in September 2018. During this time, the S&P 500 has grown from approximately 2000 points, to 2900 index points.
Notionally this is to be expected. As the economy improves, you would expect stock prices to rise as the outlook for companies improves – you would also expect interest rates to rise – as inflation and economic growth start to increase.
However, there are other forces involved that may be intensifying the correlation between US interest rates, and the US stock market.
As the implied interest rate on a bond rises, the price of the bond falls – in this way, bond prices are inversely correlated to bond yields (interest rates). With bond prices falling (bond yields rising), it means that there is selling in bonds. If people sell bonds they have to put those funds somewhere, and that means that there is likely a flow of funds to the stock market.
As long as interest rates are rising, and bond prices are falling – there is likely to be a net flow of funds from the bond market, to the stock market; the rally on the S&P500 since US interest rates started rising in late 2015 is an indication of this.
The US Federal Treasury Reserve has a fairly ambitious rate rising time-table. If you look at their “dot-plot” (the future interest rate expectation of FOMC members) you can see that there is expected to be further rate rises in the coming months and years. If this is the case, you would expect US bond yields to keep rising, which could potentially spell further gains for global stock markets.
However, the inverse is also likely true; if the FOMC puts the breaks on interest rate rises, it will likely mean a flood of money back into bonds, as bond prices would start to rise again.
This will most likely have two-pronged detrimental effect to stock prices – investors will sell down stocks because they believe the economy is weakening – and the outlook for profit growth, declining. Additionally, they will sell down shares to purchase bonds because if interest rates keep falling, the value of their bonds will rise.
Despite the fact that US stock markets continue to rise into all-time highs, it is my belief that there are some additional gains to be made. This is because economic fundamentals remain positive, and there is an expectation of further interest rate rises.
Sam Green is an advisor at TradersCircle