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Stock markets and interest rates have a complicated relationship

Sid Queler

March 23, 2022

What will happen to the stock market when the Federal Reserve raises rates?

Stock markets and interest rates have a complicated relationship

What will happen to the stock market when the Federal Reserve raises rates?

If your answer is that stocks will decline as rates increase, then you should keep reading. There is a persistent misconception among investors. Many believe that when the Federal Reserve (Fed) tightens monetary policy, the stock market will lose value. That has typically not been the case.

Table 1. How do rising interest rates affect the stock market?
When the Fed has tightened monetary policy, the Standard & Poor’s 500 (S&P 500) Index usually increased in value during the tightening cycle or the one-year period after it ended.

Source: BMO Capital Markets Investment Strategy Group, Haver, Federal Reserve
Past performance does not guarantee future comparable results

Consider Table 1, which shares data about Fed “tightening cycles” from 1983 to the present (prior to the current cycle). A tightening cycle is a period of time during which the Fed raises rates. The first column shows the length of the cycle, and the second column shows how much the Fed increased rates during that period. The final three columns show the performance of the Standard & Poor’s 500 Index, which can be used as a proxy for the United States stock market, one year before the cycle started, one year after the cycle ended, and during the tightening cycle.

During seven of eight tightening cycles and all one-year periods following a tightening cycle, the US stock market gained.

How will stocks be affected this time?
The caveat, of course, is that past performance is no guarantee of future results. With the Fed announcing a .25% rate hike on March 16th and more expected throughout the year, investors are asking how rising interest rates may affect stocks this time. The answer is that it all depends.

The relationship between stocks and interest rates is complicated. Here are four questions to consider in a rising rate environment:

How will the company’s value change? 
The reason many people believe that rising rates are bad for stock markets is because of the math behind basic stock valuations. When interest rates rise, so does the discount rate used in the fair market value equation. When future cash flows are discounted at a higher rate, stock valuations may be lower, and share prices may follow.

Inflation also is a factor. The Fed usually increases rates when the economy is strong and inflation is rising. Higher inflation reduces the value of future profits and cash flows. Chart 1 shows that stock valuations tend to be higher when inflation is lower.


Will the company continue to grow profits?

Prospects for profit growth play a role in company valuations and share prices, too. During periods of strong economic growth, stock markets overall tend to perform quite well. However, rising rates can create headwinds for businesses. A company’s share prices may hold steady or gain if the company continues to grow profits. On the other hand, if the company is undercapitalized and relies on debt rather than profit growth to keep operating, its share price is likely to suffer.

Which market sectors may benefit from rising rates?
Like individual companies, market sectors can be affected by tightening cycles. While some sectors of the market may be negatively affected, others tend to benefit from higher rates. Table 2 shows the aggregate performance of various market sectors, from the 1990s to the present, during the three- and six-month periods before the Fed raised rates and the same periods after the first Fed rate hike.

Source: Strategas. Aggregate of tightening cycles beginning in ’94, ’99, ’04, ’15 referenced in Table 1. Real Estate is only ’04, ’15. Does not include the beginning of the current tightening cycle. Past performance does not guarantee future comparable results. *Sorted.

Will bonds become more attractive relative to stocks?
As interest rates rise, the yields on bonds are likely to become more attractive. As a result, investors with lower risk profiles who have been holding dividend paying stocks because they needed income, may reallocate some of their holdings from stocks to bonds. With inflation on the rise, though, stocks are likely to remain attractive to investors because, over the long term, stocks have the potential to deliver positive real (after-inflation) returns.

No matter what happens with Fed policy and interest rates, stocks will likely remain an essential part of most portfolios. If you would like to learn more about the relationship between stocks and interest rates in a rising rate environment, contact me at sid.queler@cibc.com or 617-531.6954.