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Inflections for Interest Rates and Stocks?

How do interest rates affect stocks?


Rising interest rates tend to result in stocks falling in value because of lower future earnings. A higher inflation rate leads to higher interest rates, adversely impacting the stock market. When interest rates rise, stock investors tend to be less bullish on stocks because the value of future earnings will be less attractive to bonds.

Why are growth stocks more sensitive to interest rates?


When long-term interest rates rise, this will result in growth stocks being heavily discounted since they have longer-term cash flow horizons than value stocks. As a result, growth stocks appear less valuable, all things being equal. Rising interest favors value stocks and hurts growth stocks, at least from a relative perspective.


Why do technology stocks fall when interest rates rise?


Most technology stocks are growth stocks with high price-to-earnings ratios and low dividend payouts. Since higher interest rates slow corporate business cash flows, this can lead to a decline in reinvestment in research and development and innovation projects, lowering future growth projections.


Is it all about interest rates?


It probably depends on the longer-term direction and the duration of the rally or decline. The Fed tightening cycle has pushed U.S. interest rates sharply higher, as evidenced by the Federal Funds target rate skyrocketing from 0-0.25% (Mar 2022) to 5.25-5.50% (Jul 2023). In the process, the 10-year U.S. Treasury yield (TNX) has risen sharply higher via a series of higher lows and higher highs over the past three years.


TNX hit a 16-year high today due to stronger-than-expected manufacturing data from the Institute of Supply Management’s manufacturing index and robust August construction spending data. The weekend deal to avoid a government shutdown also hints that the Fed may need to hike rates further. Odds for a 25-bps rate hike from the November FOMC meeting have jumped to around 25%. A rate hike by the December meeting also climbs to 45%.

What is the relationship between stocks (SPX) and interest rates (TNX)?


When TNX rallied (yields rising), stocks (SPX) tend to decline, and vice versa. The actions of the bond market can directly influence the stock market and, in particular, growth areas such as COMPQ and NDX.


As the Fed raised interest rates to fight inflation, TNX has soared to a current high of 4.703% (10/02/23). At the same time, SPX recently declined to 4,238.63 (9/27/23 or -12.04% from Jan 2022 all-time high), INDU to 33,407.45 (10/2/23 or -9.59%), COMPQ to 12,963.16 (9/27/23 or -20.04%), and NDX to 14,432.60 (9/27/23 or -13.91%).


The growth and technology-related areas, including COMPQ and NDX, have underperformed their equity peers on the backdrop of higher yields.


Will the current trend continue? Or will there be a rotation back into the growth-related areas, at least near-to-medium term?


The ability of TNX to break above the top of the 42-year structural downtrend channel at 3.0-3.25% (Apr/May 2022) is technically significant. The breakout confirms a long-term trend reversal and suggests higher interest rates. Also, a recent move above key intermediate-term resistance at 4.333-4.362% (Oct 2022 and Aug 2023 highs) reaffirms higher yields toward 5.316-5.457% (Sept 2023 breakout projection and the Apr 2002 and Jun 2007 highs).


What about the overbought condition?


An overbought condition has developed, as evidenced by the RSI indicator soaring to 73.40 or close to the extreme highs of Sept/Oct 2022 (82/74). A daily Bollinger Bands study also shows yields trading above its normal daily trading range as TNX flirts with the upper end of its Bollinger Bands with a 2-standard deviation and the top of the Apr 2023 uptrend channel. Some believe the Fed may have gone too far in its tightening process, prompting a move toward lower yields.

Daily island reversal patterns like today (10/2/23) do not occur frequently and rarely after an explosive rally and near the top of its trading range.


Does this warn of a sharp rise in interest rates toward the mid-5.0%?


Or the beginning of a near-to-medium-term correction or consolidation in interest rates?


Although an overbought condition has developed, the dominant and prevailing trend is an uptrend. To achieve lower rates, TNX needs to reverse below the Sept 2023 breakout at 4.333- 4.362% and breach the bottom of the May 2023 uptrend channel (4.25%) and the 50-day ma (4.232%). A confirmed breakdown signals the start of a TNX consolidation to intermediate-term support at 4.060-4.094% (Aug 2023 breakout and Sept 2023 lows).


What does this mean for stocks and interest rates?


If interest rates continue to climb toward their next key resistance at 5.316-5.457%, this can trigger a deep and extensive stock market downturn.


Below 4,200-4,250 increases the risk for the next SPX selloff toward 3,700-3,800 (Jul/Dec 2022 and Mar 2023 lows) and below this 3,500-3,600 (Jun and Oct 2022 reaction lows).


On a positive note, TNX nears overbought levels (RSI = 73.40). SPX is also approaching oversold levels (RSI = 34.09). Since TNX and SPX are historically inversely correlated, this implies an impending inflection is close.


SPX’s ability to maintain above crucial support at 4,200-4,250 (200-day ma, May 2023 breakout, and the Oct 2022 uptrend) can solidify a market bottom and ignite another recovery phase toward the Jan 2022 all-time highs (4,818.62).


The ability for TNX to reverse below near-to-medium tern technical supports at 4.33%-4.362 and 4.232-4.25% and below 4.06-4.094% confirms a pullback in interest rates.


Will these two bullish developments play out into the seasonality strength period over the next few days to weeks?


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com


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