Should we worry about interest rates?
Research shows that changes in interest rates and bond prices are largely unpredictable. So an investment strategy based on attempting to exploit these sorts of changes isn’t likely going to be fruitful. Despite the unpredictable nature of interest rate changes, you may still be curious about what might happen to stocks if interest rates go up.
Unlike bond prices, which tend to go down when yields go up, stock prices can rise or fall with changes in interest rates. That’s because a stock’s price depends on both future cash flows to investors and the discount rate applied to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. However, it is possible that when interest rates change, expectations about future cash flows also change. What does historical data say?
Recent research by Dimensional Fund Advisors helps provide insight into this question. The research examines the correlation between monthly US stock returns and changes in interest rates. Exhibit 1 shows that there is a lot of noise in stock returns and no clear pattern, and that not much of that variation appears to be related to changes in the effective federal funds rate.
For example, in months when the federal funds rate rose, stock returns were as low as –15.56% and as high as +14.27%. In months when rates fell, returns ranged from –22.41% to +16.52%. There are many other interest rates besides just the federal funds rate, so researcher Wei Dai also examined longer-term interest rates and their changes and found similar results.
When rates go up, do stock prices go down?
To the question of ‘when interest rates go up, do stock prices go down?’ the historical answer is: Yes, about 40% of the time. In the remaining 60% of the time, stock returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up. In other words, there is not a clear link between stock returns and interest rate changes.
There’s no evidence that market watchers can reliably predict upcoming changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, the information provides little guidance about subsequent stock returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the stock market has to offer.