Beware of Rising Interest Rates

The year 1987 started out terrific for the stock market.

 

The S&P 500 gained 32% between November 1986 and August 1987. Investors were giddy. They were making piles of cash. And almost no one seemed concerned about what was going on over in the bond market...

 

After declining sharply for most of 1986, the interest rate on the 30-year Treasury bond had surged from 7.4% in late 1986 to 9.2% less than a year later. "Don't worry," the stock market pundits said. "Rising rates are a sign of economic strength."

 

The stock market fell 30% two months later.

 

Investors faced a similar situation in 1994 – though not as dramatic.

 

The stock market gained a respectable 10% from August 1993 to February 1994. Meanwhile, 30-year interest rates popped from 5.8% to over 7.2% – a 24% increase. "Don't worry," the pundits said again. "Rising rates are a sign of economic strength."

 

The stock market was down 10% two months later.

 

Then there was 2000...

 

The stock market gained 25% from February 1999 to February 2000. Interest rates went from 5.1% to 6.7% in the same time frame. Again, the pundits told us not to worry. "Rising rates are a sign of economic strength," they said.

 

The stock market gave up all of its gains by the end of 2000.

 

Fast-forward to today...

 

Investors love the stock market. And why not? The S&P 500 is up 25% over the past year.

 

Interest rates are up, too. The yield on the 30-year Treasury bond has risen from less than 2.5% last July to more than 3.6% today. That's a massive 44% rise in a year.

 

There are a few folks pointing at the rise in rates and advising caution. But a lot more are saying, "Don't worry. Rising rates are a sign of economic strength."

 

All you need to do is look at history to know interest rates have been falling for the past 30 years. As you can see, there have been times when that trend has reversed for several months. But overall, the cost of debt has been falling for a generation.

 

Now, it is likely that trend has changed. And that's a problem for the stock market...

 

Higher interest rates mean less cheap money for companies to use to expand. They cut into the bottom-line profit margins. And they mean other investments – like low-risk CDs and savings accounts – offer investors an attractive alternative to the stock market.

 

Yes, Federal Reserve Chairman Ben Bernanke has promised to keep interest rates low through 2014 and into 2015 if necessary. But the Fed only has direct control over short-term interest rates. The financial markets determine the fate of long-term rates.

 

So far, the Fed has been able to manipulate longer-term rates lower as well through its $85 billion quantitative easing program. But there is a point when the supply of debt accelerates beyond the Fed's ability to create demand. It is at that point that long-term rates will rise, despite Bernanke's promise to keep them low.

 

I suspect we reached that point last July. Since then, the trend has shifted in favor of longer-term interest rates. That would help explain why, despite the Fed's efforts to suppress it, the yield on the 30-year Treasury bond is 44% higher today.

 

Of course, I could be wrong. Maybe this blip up in rates is nothing more than a short-term pop higher, and they will head lower once again – just like they did after every other short-term pop higher over the past 30 years.

 

But it doesn't matter... Remember, the stock market hit a rough patch following each of those pops higher. So whether the long-term trend has changed or this is just a temporary uptick in rates, the outlook for stocks – at least in the short term – isn't good.

 

Best regards and good trading,

 

Jeff Clark