ARE LOW INTEREST RATES GOOD OR BAD for the stock market? As you are painfully aware, interest rates in general are very low. There are three main reasons for this:
1. Consumer demand for interest-bearing products is relatively high.
2. Business demand for loans is relatively low.
3. Central banks in many developed nations are engaged in an "easy money" policy.
Source: The Economist
All three of the above are associated with the fact that our economy is relatively weak. In difficult economic times like today, central banks have a vested interest in keeping rates low. The thinking is low rates will reduce the "hurdle rate" for businesses to reinvest and, as a result, encourage them to expand and hire new people. As businesses expand, the economy will grow and begin a new virtuous circle.
So, let's see if this virtuous circle of low interest rates applies to the stock market, too.
Using data from the Barclay's Capital Equity-Gilt study, The Economist took a look at U.S. stock market returns between 1926 and 2011 and sliced the data into periods when the real rate on Treasury bills (the rate after subtracting inflation) was positive and negative. What they discovered was startling:
"In the 33 years where real yields have been negative, the average gain from equities has been 2.3%; in the years when real yields were positive, the average gain was 6.2%."
In other words, low real interest rates (which we have today) have typically been associated with low stock market returns.
As we all know, data can often be presented in ways that support whatever position you're taking (just like in the past election cycle!). So, putting that aside, the key is to interpret the data. Since we've been in a low rate environment for a long time, stock prices have likely had time to adjust accordingly. The key now is to watch for the turning point - the time when rates start a new rising trend.
When rates start to rise, that could signal the economy is on the mend as businesses start demanding more money for loans to expand and central banks pull back on the easy money policy to avoid too much inflation. This would be a "good" reason for rates to rise. Alternatively, rising rates could signal investors are losing faith in our country's ability to pay its bills. This would be a "bad" reason for rates to rise.
We're watching interest rates closely for any sign of a new trend and, importantly, the reason behind that trend. It's just one of many indicators we monitor as we keep a close eye on your investments.