Rising Interest Rates, Inflation, And Stocks

PAST DATA
In December 2008, the interest rate on the 10-year ($TNX) approached 2.0%, a record low. Since then, the rate has risen by almost 90% in less than six months, a rate of change that would be viewed as a skyrocketing runup in any market. A quick look at a long-term chart shows this is the fastest increase in recent history (Figure 1). The data is easier to see in Figure 2.

FIGURE 1: Over the last 10 years, long-term interest rates have repeatedly moved sharply higher and lower.

FIGURE 2: Interest rate moves are sharper and more frequent than most investors realize.

From this more extensive data series, we can identify that the current rate environment is the sharpest five-month increase among the 670 available observations. This offers a starting point to study changes in the economy and the stock market after other sharp increases in interest rates.

Figure 3 offers insight into economic growth after the sharp rise in rates. The median change in GDP in the quarter following the previous nine greatest increases in interest rates was 6.6%. Compare this with a median GDP change of zero percent over the entire time frame. Conventional wisdom is that higher interest rates can choke off economic activity. The data shows the opposite is true; sharply higher rates are actually an indicator of greater than normal economic gains.

FIGURE 3: Large changes in GDP usually follow sharp increases in interest rates.

FIGURE 4: Inflation is only slightly higher after large increases in interest rates.

Stocks are said to be inversely correlated with interest rates; as rates go higher, bonds become more attractive relative to stocks, and therefore, stock prices would be expected to decline. On average, however, the data does not support this. The three-month average gain in the Standard & Poor’s 500 after the previous nine interest rate spikes was 3.31%. This compares with an average gain of 1.89% in all three-month periods. After an interest rate rise of this magnitude, stocks averaged a gain of 6.86% in the next six months. The average gain over all six-month periods was 3.87% from April 1953 through May 2009. Figure 5 provides the detailed history.

FIGURE 5: Stocks tend to be volatile after rapid increases in $TNX.