How are Interest Rates Related to the Stock Market?

Published June 2nd, 2017 

Reading Time: 4 minutes

Written by: The Zoe Team

Do interest rates have an effect on the stock market? We took a look into US and foreign stocks and their relationships to interest rates.

The relationship between stocks and interest rates depends on the interest rate level you are starting from.

Below chart from JP Morgan illustrates how the historical relationship between equities and a 2-year treasury yield is positive when rates are rising from a very low level (like they have been the last few years). Once rates rise above 3–4%, the relationship turns negative with equities. 

Why? A good explanation is that usually when rates are above these interest rate levels, it means the economy is overheating and inflation is starting to become a headache for the Fed and forces them to keep hiking interest rates. This type of environment usually leads to equity bear markets as the economy turns from expansion to deceleration or outright recession.

The relationship between stocks and interest rates depends on the interest rate level you are starting from.

Below chart from JP Morgan illustrates how the historical relationship between equities and a 2-year treasury yield is positive when rates are rising from a very low level (like they have been the last few years). Once rates rise above 3–4%, the relationship turns negative with equities. 

Why? A good explanation is that usually when rates are above these interest rate levels, it means the economy is overheating and inflation is starting to become a headache for the Fed and forces them to keep hiking interest rates. This type of environment usually leads to equity bear markets as the economy turns from expansion to deceleration or outright recession.

For non-US stocks, the relationship to interest rates is not as important as the stock’s relationship to the US Dollar.

I did a fairly robust study on this and found that foreign stocks, especially in the “emerging markets” have a strong negative relationship to the US dollar. Why does that matter? Because regardless of whether interest rates are rising or falling, if the US dollar is rallying, emerging market stocks historically suffer significantly underperformance. And that underperformance can last 5–7 years since that is how long US dollar cycles last (the drivers of the dollar cycle is for another blog). Currently, we are in year 6 of a very strong US dollar cycle which has really hurt Emerging Market stocks (especially vs. US stocks performance). The big question here is “is the US dollar bull cycle done?” if it is, Emerging Markets could see a significant outperformance vs. US stocks over the next few years.

To summarize:

    • If US interest rates are at a low level and rising, equity markets tend to rally as the economy tends to be in a recovery/expansion stage
    • If US interest rates are at a high level (Above 3–4%) and rising equity markets tend to have negative performance
  • For international stocks, historically, the relationship of the US dollar with stocks is more important than stock’s relationship with US interest rates.

This blog was initially posted as an answer on Quora.com. 

Disclosure: This blog is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

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