What Happens to Stocks When Interest Rates Change?

Research shows that interest rate changes are largely unpredictable. This is not surprising because current interest rates reflect the aggregate expectations of all market participants including the potential actions by the Federal Reserve and other market forces. Well, there's no evidence that anyone can accurately predict interest rates but many investors may still wonder what would happen to equity returns when interest rates go up or down. What we found is that the relation between equity returns and interest rate changes has not been clear and does not offer useful guidance for investing. To examine the relation, we looked at whether interest rate changes and equity returns moved together in the historical data. Since interest rates at different points of the yield curve do not move in lockstep, we examine a variety of interest rates. What is the effect of federal funds rate, which is an overnight rate at which banks lend money to each other. We also looked at longer term interest rates. Such as the yields for 10 Year Treasury Bonds. If there were a strong relation between equity returns and interest rate changes, we would expect a clear pattern when plotting the data points. Shown here is an example that illustrates a positive relation between the variables. However, the relation based on actual data is much noisier than this. This graph plots the equity returns against the monthly changes in the effective federal funds rate from August 1954 to December 2016. As you can see, there's no clear pattern. And a lot of the variation in equity returns was unrelated to interest rate changes. In months when rates rose, equity returns were as low as -15.6% and as high as 14.3%. In months when rates fell, the range of equity returns was just as wide from -22.4% to 16.5%. The relation between longer term rates and equity returns is also noisy. As shown in this graph, over the sample period from February 1962 to December 2016, changes in the 10 Year Treasury Constant Maturity Rate did not have clear impacts on equity returns. So the evidence suggests that even if you had perfect foresight of future interest rate changes, it would not help you to explain variation in equity returns. What are the main takeaways for investors? The relation between equity returns and interest rate changes is weak and very noisy in the historical data. Even perfect knowledge of future rate interest changes would provide little insight into future equity returns. Staying disciplined and avoiding speculations puts investors in the best position to capture equity returns in any interest rate environment.