Why Rising Rates Could Be Bad--and Good--for Stocks
Investors large and small in the 1990s have been consistently willing to give the U.S. stock market the benefit of the doubt.
Foreign crises, domestic political scandals, isolated financial catastrophes, slower corporate earnings growth--none of this has mattered much, or for very long, to Wall Street.
And despite constant moaning from the market’s detractors that share prices are too high, cash dividend yields too low, blah blah blah, the fact is that the current U.S. economic expansion completed its 94th month in December. That’s longer even than the 92-month Reagan-era expansion of 1982-90.
When the economy is growing, you pretty much want to own stocks--or at least certain stocks. That’s the fundamental reason why the Dow Jones industrial average, at 9,304.24 now, has risen 253% since the end of 1990, when it closed at 2,633.
But last week brought a reminder that there is one force with which U.S. stocks can’t easily contend: rising interest rates.
Amid a constant stream of government reports pointing out what most Americans know instinctively--that the domestic economy is sparkling--traders who buy and sell bonds for a living engaged in their classic conditional logic.
Which goes like this: “If the economy is growing too quickly, then the cost of money [interest rates] will rise, because more individuals and companies will be competing for credit.”
Or, more to the point: “If the economy is growing too quickly, then the Federal Reserve will itself raise the cost of money to keep things from overheating.”
Reasonable people, even some on the Fed board, will continue to disagree over what exactly is too fast for economic growth.
To his credit, Fed Chairman Alan Greenspan has in recent years been willing to allow the economy to expand at a pace much brisker than what he might have tolerated in, say, the 1980s. The near-absence of inflationary pressures, amid plunging commodity prices and rising worker productivity (thank you, Silicon Valley!), has amazed economists and forced the Fed to raise the bar for permissible growth.
But central bankers tend to become central bankers because they are genetically programmed to worry incessantly about inflation.
And so it was last week, as the economic data pointed to a possible acceleration of U.S. growth in December and January, that bond traders recalled Greenspan’s testimony before Congress late last month--in which he stated that the economy “has continued to grow more rapidly than can be accommodated on an ongoing basis.”
Translation: If this keeps up, the Fed--which generously cut rates three times last fall after Russia’s economic crash--will raise rates sooner than later, assuming Brazil’s economic situation stabilizes and the world backs off further from the Asia-induced financial crisis of the last 18 months.
The Fed obviously isn’t trigger- happy. Greenspan and cohorts met last Tuesday and Wednesday and opted to leave their key short-term interest rate, the federal funds rate, unchanged at 4.75%.
But bond traders don’t wait for the Fed. They typically begin demanding higher yields on bonds well in advance of Fed rate hikes.
On Friday, after the government said a net 245,000 new jobs were created in January--well above estimates--long-term bond yields jumped for a fifth straight session. The yield on the 30-year Treasury bond, a benchmark for long-term rates in general, ended at 5.35% Friday, up from 5.29% Thursday and the highest since Nov. 6.
Is that a big deal? Certainly not yet. That yield was above 6% just a year ago. What’s more, there may be temporary forces pushing Treasury yields higher in the near term--specifically, the government’s quarterly auction of $35 billion in five-, 10- and 30-year securities this week.
Still, historically nothing rattles the stock market’s cage like higher interest rates. At the level of big institutional investors, the continuous debate is: Own stocks, or own something that pays interest, meaning bonds or money market securities? Higher interest rates mean greater competition for money that would otherwise choose stocks automatically.
So it’s probably not just coincidental that the Dow average has been stuck between 9,200 and 9,400 for the last two weeks, after peaking at a record 9,643.32 on Jan. 8.
Or that the tech-stock-dominated Nasdaq composite index slumped 5.4% between last Monday’s record high and Friday.
Could a further rise in bond yields trigger a significant stock sell-off--something in the range of a 10% market decline? History says there’s a reasonably good chance of that. The question is how high yields would have to go before reaching stock investors’ threshold of pain. Maybe we’re getting there; maybe we’re not. At the very least, it’s clear the market now is watching rates much more intently.
As for the Fed--well, it still seems likely that Greenspan is on hold. Most economists seem to think the Fed won’t seriously consider raising short-term rates before summer. But then, most economists didn’t expect to see January’s job growth, either.
Two points worth keeping in mind: First, whatever the Fed decides to do, it isn’t interested in killing the economic expansion, just keeping it manageable. In that context, any drop in stocks caused by higher rates probably becomes a good buying opportunity.
Second, the Fed is believed to be very worried that the stock market is far more overheated than the economy. So Greenspan would probably like nothing better than for Wall Street to do his job for him: In other words, bond yields would rise further, the stock market would sell off (though not too much), and the economy would slow as a result of both those developments. (Money temporarily becomes more expensive, and consumers feel a bit poorer.)
But all that would do, ideally, is set the stage for an even longer economic expansion (as per Point 1). And ultimately, expansion is the stock market’s best friend.
Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.
