The Fed’s Decision: Interest Rate Changes and Stock Returns

2:00 PM on September 17^th has been circled on investors’ calendars for months. That is the date and time the Federal Reserve releases the minutes from its September meeting announcing whether interest rates will be kept at the current, near 0 level or begin the first rate hike as the US economy continues to get back on its feet.

Predictions for what a rate hike means for stocks are in vogue with the general belief that rising interest rates are bad for stocks in the short term but more nuanced takes predict that there is really not much to worry about.

We decided to check on how changing interest rates and stock prices interact to gain an understanding of what to expect when the Fed inevitably does begin to raise interest rates.

Using the 14 year period that Treasury bill rates are available from August 2001 to August 2015, we regressed the returns of the S&P 500 against two interest rate factors, the 10-year treasury yield and the difference between the 10-year and 1-month treasury yields, known as the term spread.

The level of interest rates did not affect stock prices but the change in interest rates did – as interest rates increased, stock returns suffered. This makes intuitive sense as higher interest rates increase borrowing costs for firms, limiting economic activity and eating into corporate earnings.   Changes in the term spread were also significant: as the difference between short-term and long-term interest rates shrink stock returns suffer.  This also is not surprising as the term spread tends to widen during ecomomic expansions.

But this is a static view and we want to also look at the data dynamically.  Running regressions on a five-year rolling window allow us to track changes over time and, as the chart above strikingly shows, a recent change in the way the S&P 500 reacts to long-term interest rates and the yield curve is evident.  This change in the long term pattern could be caused by the Federal Reserve’s extraordinary monetary policy following the 2008 market crash that may have structurally changed the path of the interest rates themselves.  A recent report from the Council of Economic Advisers suggests that long-term interest rates in the United States have been consistently falling and, in the long run, will remain lower relative to those that prevailed before the financial crisis.  Because long term interest rates are difficult to predict and the stock market’s sensitivities to these interest rates are changing, the data does not support that stocks will drop when rates rise. 

Jeremy Siegel even provides the provocative case should the Fed begin raising rates, stocks will rally as uncertainty is removed from the market and assurances are made that the rise in interest rates will be gradual. There may be some volatility as a result of the Fed’s actions tomorrow but equities can still rise once the dust settles.