What is the historical relationship between interest rates and the stock market?
Interest rates are the cost of borrowing money. Interest rates fluctuate based on the compensation for bearing higher or lower risks. Interest rates are also a factor of the supply and demand equilibrium of credit. The interest rate assigned to different types of loans depends on several factors such as credit risk, time duration, tax consideration, and convertibility of the loan.
The stock market is driven by several factors such as supply and demand, fundamental factors, technical factors, economic conditions (i.e., inflation, recession, deflation, etc.), business cycles, FED central bank policies, liquidity, market sentiment, structural trends, demographics, and demand for substitute assets (i.e., bonds, commodities, real estate, foreign equities, etc.).
Historically, the relationship between interest rates and the stock market is an inverse correlation. The two markets tend to move in opposite directions. When the Federal Reserve cuts interest rates, it generally causes the stock market to go up. On the other hand, when the Federal Reserve raises interest rates, it causes the stock market to go down.
What is the relationship between interest rates and business/consumers?
When interest rates rise, businesses, corporations, and consumers tend to cut back on spending, expenditure, investing, etc. The decrease in demand can lead to corporate earnings falling and stock prices declining. Conversely, when interest rates decline significantly, consumers and businesses will likely increase spending, causing stock prices to rise.
The stock market and mortgage rates are not always entirely related as some believe. Yes, mortgage rates can impact the housing market. But most mortgage loans are backed by mortgage-backed bonds, which is part of the bond market. When the bond market (prices rise) is doing well, interest rates fall. When investors sell bonds, this results in interest rates rising, which leads to a rise in mortgage rates.
Covid-19 pandemic, stay-at-home economy, and the U.S. housing boom
Last year the Covid-19 pandemic plunged the United States into a recession, leaving millions of Americans out of work, hungry, and homeless. However, amid the pandemic, the U.S. housing market boomed. The controversial housing boom is probably the direct result of health concerns, a stay-at-home economy, low housing inventory, and historically low mortgage rates.
The recent rise in the U.S. 10-year Treasury yield (TNX) has begun to attract widespread attention from Main Street and Wall Street. Since most long-term mortgage rates (i.e., 30-year) are based on the benchmark yield, rising long-term interest rates will eventually lead to a rise in long-term mortgage rates as well.
Inflection points in 10-year treasury yield (TNX) and 30-year Treasury yield (TYX)
The rise in interest rates may be nearing an inflection point, at least from a technical perspective. TNX is challenging its pivotal 2018 downtrend at 1.17-1.18%. The U.S. 30-year Treasury yield (TYX) has broken out above its 2018 downtrend above 1.75% on 1/6/21 but is now approaching its 2.00% psychological barrier.
Although TNX is more popular, TYX remains a crucial interest rate barometer as the latter is most sensitive to inflation pressures. The 2% in TYX may become increasingly important as the outcome may influence interest rate trends in the future. A convincing breakout above 2% confirms the next intermediate-term rally in TYX toward 2.15% (50% retracement from 2018-2020 decline). Above 2.15% suggests the next move to 2.41-2.46 (Jan 2021 ascending triangle breakout target, Nov/Dec 2019 highs, and the 61.8% retracement from 2018-2020 decline). A convincing surge above 1.17-1.18% warns of the next TNX rally toward 1.43-1.51% (Sep/Oct 2019 lows, Feb 2021 breakdown, 1/5/21 ascending triangle breakout, and the 38.2% retracement from 2018-2020 decline), and above this to 1.82-1.97% (50% retracement from 2018-2020 decline and the Nov/Dec 2019 highs).
In summary, convincing breakouts above 1.17-1.18% for TNX and above 2.00% for TYX will likely lead to rising inflationary expectations, among other things.
What will happen to stocks?
So, the pertinent question is - will stocks rise or fall as interest rates rise?
Based on the long-term historical relationships between interest rates and stocks, conventional thinking implies stocks will fall, and the housing market will collapse in response to higher interest rates. However, in the current environment, convincing breakouts above key resistances in TNX and TYX also suggest continued selling of US treasury bonds. The proceeds from the selling of bonds may end up in the stock market possibly as a hedge against rising inflation expectations. The stay-at-home theme, tight inventory, and the fear of higher mortgage rates in the future may propel buyers into the housing market and higher home prices.
Since March 2000, at the height of the pandemic, a paradigm shift may have reversed the long-standing traditional inverse relationship between interest rates and stock prices. Higher bond yields may now fuel the further advance in stocks. The direct relationship between higher interest rates and stock prices may continue for the foreseeable future as the FED shows no signs of reversing their accommodative stance in interest rates. It also seems the stock market may be pricing in higher inflation expectations. The massive fiscal stimulus programs, rebounding commodity prices, and a recovering economy can lead to more money leaving the bond market and finding its way into the stock market.
Stock market melt-up?
Although it may be controversial, if TYX and TNX indeed breakout above their respective resistances and yields) and trend higher this will likely lead to the continuation of the current structural bull trend in stocks. If the speculation becomes broad-based, then this may trigger the elusive stock market melt-up phase.
Just as stock market crashes teach investors not to take on more risks than warranted, stock market melt-ups teach investors to avoid taking below-average risks. As market crashes often show the emotional response is fear and the benefits of diversification, melt-ups will also reveal fear - the fear of missing out on the market rally and the underexposure of your portfolio to the parts of the stock market that are dramatically outperforming the market.
Investors who make mistakes during big bull rallies feel vulnerable and exposed. In a market crash, everyone is losing money, so it does not feel all that bad. However, in a roaring bull market, when everyone is making money except you, it is much tougher to stomach the consequences.