Wednesday, April 13, 2011

Higher interest rates will not be bad for stocks


Many observers and investors worry that stocks are going to be hit when the Fed starts to raise interest rates, especially if they move too soon to tighten. I've maintained for a long time, in contrast, that an early tightening of monetary policy would be good for stocks. This chart shows that investors' fears are not necessarily well-founded.

The ECB last week surprised the world by moving sooner than expected to lift its short-term interest rate target. I wrote last week that this was a good thing, and noted that pre-emptive monetary policy tightenings have been very good for the euro, the Aussie dollar, and the Canadian dollar.

The chart above extends that observation to the stock market. German 2-yr yields, which are the market's best guess for what the ECB's target rate will average over the next 2 years, have soared from a low of just under 50 bps in June, 2010, to now almost 190 bps. This move was driven by the ECB's sooner-than-expected tightening of monetary policy, and the rise in rates closely parallels the new-found strength of the European stock market.

This is not surprising, of course, since a central bank's moves are almost always a complicated dance between the market's perception of the economy's strength, and the central bank's perception of that same strength. Sometimes the market signals the central bank that a move is Ok, and sometimes the central bank guides the market. In recent months the European economy is looking better, the central bank is more concerned that inflation might be picking up, and the market is happy that the ECB is not going to slip behind the inflation curve without a fight.

I would anticipate, therefore, that an earlier-than-expected tightening move by the Fed would be greeted with similar enthusiasm. Tighter policy would acknowledge that the economy is in better shape, and at the same time reassure markets that the Fed is anxious to stay on top of things, rather than fall further behind the inflation curve. Confidence in the future, and confidence in one's currency, are very important sources of support for equity prices.

7 comments:

sgt.red.blue.red said...

The Fed raised interest rates from 2nd Quarter 2004 through mid 2006, and then rates flat until after the the August, 2007 stock market 'break'. It was the cumulative effect of several years of rate increases that (ultimately) tanked the economy.

The initial rate increases off the present lows shouldn't have any negative effect to the market and economy. It would help the dollar.

Dr William J McKibbin said...

I tend to agree that rising interest rates are unlikely to derail stock values in the coming months or years -- in fact, dividend paying stocks and rent-paying real estate will likely benefit from a rise in interest rates, yes...

brodero said...

I agree the first 100bps (probably
even more than that) will not hurt the economy...in fact it might actually help...I watch the spread between Baa yields and 3 month libor and we are very far away from
a danger zone on that spread....

TradingStrategyLetter - Weekly Summary said...

You sure do send clear thoughts and messages. I know no better source.

puffer said...

Scott -

Won't a tightening actually reduce inflation expectations and therefore reduce the yield on the long end, making TBT a tenuous bet?

Scott Grannis said...

An early tightening might result in stable long-term bond yields, but I would bet that initially they would rise. Nevertheless, if you expect an early tightening then the potential gains to a long TBT position are going to be much reduced and thus less attractive.

Family Man said...

@brodero
Are this swaps data (Baa vs libor) available somewhere for free?