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US Economy

The Truth about Higher Interest Rates

By Elliott H. Gue, on Mar. 31, 2014

The yield on the 10-Year US Treasury Note currently stands around 2.75 percent, up from a low under 1.40 percent in July 2012.

I’m often asked if the recent jump in interest rates will short circuit the US economic recovery or the recent rally in the S&P 500.

I also have read myriad articles on popular websites asserting that rising 10-Year yields or rising interest rates are bad for the economy and stock market.

That’s a complete fallacy: There’s little statistical correlation between the 10-Year yield and performance of the S&P 500. In fact, rising rates can often be good news for the stock market.

Source: Bloomberg

Between March 1971 and January 1973 the yield on the 10-Year Note jumped from 5.5 to 6.76 percent. But, that was good news for stocks – the S&P 500 rallied from around 90 to close to 120 over the same time period, a gain of around 30 percent.

And 10-Year yields soared from 8 percent to nearly 11 percent between March 1978 and November 1979 while the S&P 500 managed a gain just shy of 20 percent over the same time period.

Of course, the 1970’s were a period of generally rising rates while rates have generally fallen in the US since 2000. Despite that distinction, the correlation between 10-Year yields remains dubious.

Source: Bloomberg

Between 2000 and 2009, interest rates and the stock market were positively correlated. Rates and stocks fell sharply between 2000 and 2003, rose sharply between 2003 and 2007 and then fell sharply again amid the 2007-09 financial crisis and recession.

Over the entire period from March 1964 to March 2014, the correlation between the S&P 500 and the yield on a 10-Year Note is just -0.014 percent and that number is statistically insignificant. A correlation coefficient that close to 0 indicates there is no relationship between stock performance and the 10-Year yield.

And the 10-Year yield is positively correlated to US economic growth. When the economy is strong, market participants begin to price in the likelihood of rising inflation and the need for the Fed to combat rising prices with higher interest rates. Yields tend to fall quickly during recessions; for example, in the 2007-09 downturn the yield on the 10-Year plummeted from a 2007 high of over 5.3 percent to just over 2 percent by the end of 2008.

But while rising interest rates don’t spell doom for either the US economy or stocks, the shape of the yield curve is one of the most reliable recession indicators you’ll encounter. Numerous academic papers have established a tight statistical correlation between US economic growth and the spread between 10-Year and 3-Month US Treasury yields.

Source: Bloomberg

When this spread is negative, the US yield curve is inverted meaning that short term interest rates are higher than long-term rates.

An inverted yield curve is a powerful predictor or looming recession for the US economy. For example, the yield curve inverted for several weeks in the summer of 2006, roughly 18 months before the start of the vicious 2007-09 downturn. Prior to 2006, the last time the yield curve inverted was April 2000, just under a year before the economy officially entered recession in March 2001.

The yield curve has given some false signals as well. For example, the yield curve inverted in 1998 amid the Russian financial crisis and debt default but the US economy never entered recession and the yield curve re-steepened in 1999.

Despite these missteps, the yield curve has an outstanding track record over the long term and is included in several indicators of US economic performance such as the Conference Board’s US Leading Index.

Yield curve spreads contain a great deal of information about the stance of the Federal Reserve and market expectations for future growth and inflation. The yield curve can invert because short-term interest rates (90-day paper) rise sharply, because long-term rates (10-year bond yields) fall quickly or some combination of these two factors.

When short-term rates rise sharply, it’s often an indication that the Fed is hiking interest rates to curtail inflation or prevent the economy from overheating. A series of modest rate hikes usually isn’t enough to invert the yield curve. And, if market participants remain optimistic about the US economy’s long-term growth prospects, long-term rates are likely to remain significantly higher than short term rates.

However, if the Fed aggressively hikes rates, short term rates can rise faster than long-term rates, inverting the yield curve.

When long-term rates are relatively high, it indicates that market participants are optimistic about US economic growth. A high or rising 10-Year yield suggests that investors are demanding higher yields to compensate for the risk of rising inflation and the need for the Fed to hike interest rates to combat that inflation in the future. Inflation expectations usually rise during periods of strong economic growth, pushing up 10-year yields.

The current 3-Month to 10-Year spread is just under 2.7 percent. The spread has narrowed since 2010 but remains steep by any historical comparison.

Despite the fact that the US Federal Reserve continues to taper the pace of quantitative easing and Fed Chairwoman Janet Yellen has made an effort to warn the market that the central bank many need to hike rates as soon as next year, monetary policy is the US remains highly accommodative by any historic yardstick.

The recent uptick in the 10-Year yields is also bullish. Rising longer term rates suggest that investors are pricing in strong US economic growth in years to come and, quite likely, higher inflation.

Several researchers have developed models that forecast the risk of a recession over the next 4 quarters (1 year) based on yield curve spread data. With the yield curve this steep, most of those models show the probability of a US recession over the next year at well under 2 percent.

Bottom line: Rising interest rates will not harm the recovery and we expect stronger economic growth this year to support a generally rising stock market.

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