Money Brain: Here’s how to think clearly about the Fed, stocks, and interest rates

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Interest rates are making headlines again. Are rates going up or down? Is this good news, bad news, or no news for the stock market? These are important questions and I’d like to suggest a few fundamental principles.

For almost 50 years, from 1959 through 2007, the 10-year U.S. Treasury TMUBMUSD10Y, -0.23%  rate averaged 6.86% and was seldom below 4%. Since 2007, the 10-year rate has averaged 2.60% and has rarely been above 4%. The current historically low level of interest rates have led many to predict that rates will inevitably go back up to “normal” levels.

Not so fast. In the 1960s, for example, mortgage rates went above 6% for the first time in anyone’s memory, leading many homebuyers to put off buying homes until mortgage rates returned to “normal” levels? They had a long wait. Mortgage rates stayed above 6% for almost 40 years.

There is no such thing as a normal interest rate that exerts a magnetic force whenever rates wander from normal. Interest rates can be high or low for decades. We get used to interest rates being at certain levels because we have a natural human tendency to use reference points when making decisions, a human tendency known as anchoring.

For example, people were asked one of these two questions:

“The population of Bolivia is 5 million. Estimate the population of Bulgaria.”

“The population of Bolivia is 15 million. Estimate the population of Bulgaria.”

Those who were told that Bolivia’s population is 15 million tended to give higher answers for the population of Bulgaria than those who were told that Bolivia’s population is 5 million. People use a known “fact” as an anchor for their guesses. In the same way, people use historical interest rates, home prices, and stock prices as anchors.

Future interest rates will not be determined by past rates, normal or otherwise, but by future supply and demand — which is notoriously difficult to predict. It is no easier to forecast interest rates (and bond prices) than it is to predict stock prices. They certainly cannot be predicted accurately by conjuring up a myth of “normal” interest rates.

Now, suppose that interest rates do increase. How will the stock market be affected? Short-term rates don’t matter much. Stocks are long-term assets with long-term cash flows, so their fundamental values depend mainly on long-term interest rates — the 10-year Treasury rate is a convenient benchmark. The Fed sets short-term rates, but the bond market sets long rates, based on expectations about the economy, inflation, and future Fed policy.

The Fed has increased short-term rates four times in the past 12 months, with only modest effects on long-term rates and the stock market. Longest-term Treasury rates are barely above 3%, reflecting bond market expectations that interest rates are most likely to stay below 4% for several more years. (Savvy investors will not buy 30-year Treasuries yielding 3% if they expect interest rates to be above 4% anytime soon.)

What if the bond market is wrong and long rates increase substantially? The award for the most useless (and potentially dangerous) advice goes to those who argue that since, historically, the average correlation between interest rates and stock returns has been near zero, investors should assume that an increase in interest rates will have no effect on the stock market. That is like the statistician who drowned crossing a river with an average depth of 12 inches.

Higher long-term interest rates unambiguously reduce the present value of any given cash flow — whether it is coupons from bonds, dividends from stocks, or rents from commercial property.

But that argument assumes everything else being equal, and everything else is seldom, if ever, equal.  The fact that higher interest rates reduce the present values of stocks and bonds does not mean that their prices move in lock-step, since stock prices depend on the economy (and human emotion).

When interest rates rise, bad economic news will reinforce the decline in stock values, while good economic news will cushion the drop, perhaps even propelling stock prices upward at the same time that bond prices are falling. When interest rates decline, good economic news will reinforce rising stock values while a weak economy will restrain stock values. Add in human emotion and, sometimes, bond and stock prices move in the same direction; other times, they move in opposite directions.

There have been many years when stocks and bonds both did well and many years when both did poorly — their returns were positively correlated. However, there have also been years when one did well and the other poorly — their returns were negatively correlated.

For example, someone who created a portfolio of Treasury bonds and the S&P 500 SPX, -0.29%  in 1955 would have seen that the correlation had been positive over the previous five-to-10 years. This investor might have assumed the same for the next five-to-10years, but the correlation turned out to be negative. Then, in 1965, the opposite was true. Looking backward, the correlation had been negative; going forward, the correlation turned out to be positive.

The 1960s were a recession-free decade marked by increases in U.S. private and government spending. The resulting robust economy increased borrowing and interest rates. The rise in interest rates reduced bond prices, but stock prices increased because the negative effects of somewhat higher interest rates were overwhelmed by the economy’s strength. This coexistence of higher interest rates and larger corporate profits produced a negative correlation between bond and stock prices.

Other historical periods have been dominated by the Federal Reserve raising interest rates to cool the economy and slow inflation, or lowering interest rates to stimulate the economy when it seemed on the verge of collapse. A rise in interest rates that brings an economic recession will cause bond and stock prices to fall together; a decline in interest rates that brings an economic boom will cause bond and stock prices to rise together. In these circumstances, bond and stock prices are positively correlated.

Today, looking forward, it doesn’t matter at all what the average relationship has been between interest rates and stock prices over the past five-, 10-, or 80 years. Investors should think about likely scenarios involving both the interest rates and the economy:

1. Do you believe that long-term interest rates are more likely to rise or fall?

2. Do you believe that the economy is more likely to strengthen or weaken?

One scenario is that inflation will pick up and the Fed will jack up interest rates in order to clobber the economy and kill inflation. That is not a happy outcome for the stock market.

Another scenario is that the economy keeps growing and the Fed allows interest rates to drift upward to restrain inflation. That is an okay outcome for the stock market.

A third possibility is that the economy softens and the Fed lowers interest rates to prevent a recession. That is another okay scenario for stocks. What is your most likely scenario?

 I have three suggestions for thinking clearly about interest rates:

1. Watch out for anchors that might sink you.

2. The future will not be an average of the past.

3. Think about the economy and interest rates, not just interest rates.

Gary Smith  is the Fletcher Jones Professor of Economics at Pomona College and author of  “Money Machine: The Surprisingly Simple Power of Value Investing.”  (AMACOM, 2017)