Saturday, December 30, 2006

Interest Rates and the Stock Market: Have Rising Rates Mattered to Traders?

We finished the 2006 trading year making 20-day highs in the interest rate on the 10-year Notes ($TNX). Have rising rates been affecting stock returns for traders? I decided to take a look by going back to 2004 (N = 729 trading days).

Since that time, we've had 103 occasions in which the rate on the 10-year Note has made 20-day highs. (Observe that this means the Note itself made 20-day price lows). When that has occurred, the S&P 500 Index (SPY) has averaged a gain over the next three weeks of only .07% (56 up, 47 down). Conversely, when the 10-year rates have not made new 20-day highs (N = 626), the next three weeks in SPY have averaged a gain of .54% (389 up, 237 down). It would appear that returns have been subnormal after rates have been rising.

The rate on the 10-year Note has only been above 5% for 67 trading days, and these were clustered during the period of April-July, 2006. Three weeks after these occasions, SPY averaged a decline of -.47% (25 up, 42 down). When rates have been below 4.1% (N = 118), however, the next three weeks in SPY have averaged a gain of .97% (76 up, 42 down). Could it be that the market interprets rates above 5% as potentially damaging to the economy and hence to stocks?

Finally, when 10-year rates have risen by more than 5% in a 20-day period (N = 126), the next three weeks in SPY have averaged a loss of -.20% (53 up, 73 down). When 10-year rates have dropped by more than 5% over the past 20 days (N = 79), the next three weeks in SPY have averaged a gain of .78% (50 up, 29 down). Large rises (declines) in rates appear to have been associated with subnormal (superior) returns in the near term.

Clearly, the recent equity index market has preferred low rates to high ones. The recent rise in rates is one factor that may subdue near-term returns.


Anonymous said...

Hi Brett,

I enjoy the analysis but wish you would incorporate at least one full economic cycle.

A couple of comments on your thoughts:

"It would appear that returns have been subnormal after rates have been rising." This maybe the case for the 10y note but keep in mind that the Fed has been lifting rates in the shortend from 1% to 5.25% which leads to your last point:

"Large rises (declines) in rates appear to have been associated with subnormal (superior) returns in the near term."

Broadly, increasing short rates (and historically long rates via expectations) has been positively correlated with the equity market. The term structure is low when growth and inflation are weak (recession) and rises as they recover (expansion). In 2003 the equity market bottomed after the last Fed rate cut. Perhaps the first cut, Q2 on current market pricing, may signal the end of this bull market?

Brett Steenbarger, Ph.D. said...

Thanks for those excellent observations. I agree that a look at interest rates and equity prices across many economic cycles yields interesting perspectives. Most of my blog posts simply emphasize how markets are behaving during the most recent "regime". Those regimes change over time, of course, so it becomes important to be on the lookout for shifts in the intermarket relationships. Thanks again for your observations.


yinTrader said...

Hi Brett

May I add another perspective on interest rates regarding housing which is a factor affecting our market sentiment.

Markets are often ahead of the Federal Reserve. Interest rates are determined every day in active public markets.

If those markets believe the economy is slowing, interest rates may fall as markets anticipate that the Federal Reserve might lower short-term rates.

This happened in the last half of 2000 when mortgage rates began steadily dropping, even though the Federal Reserve left their short-term rates unchanged.

The opposite can happen as well. Mortgage rates can rise well ahead of the Federal Reserve increasing short-term rates.

It's almost impossible to accurately predict the future of the U.S. economy.

FWIW: Just want to have a chance to wish you and all here a Happy New Year

Brett Steenbarger, Ph.D. said...

Thanks, Yin, for those perspectives. I agree that it is tricky indeed to predict the economy. In general, rates tend to rise prior to a business cycle peak in equities, but the lead time can be quite variable. My concern for the bull market would be heightened if we saw rates creeping back toward that 5% level. Have a happy New Year!


Paolo Pezzutti said...

Dear Brett,
it would be interesting also to do some testing about the relationship between interest rates vs. US Dollar-Euro.
Also the relationship US Dollar-Euro and equities is much discussed.

I am not sure however we could find any type of correlation that could be traded by the average investor.



Brett Steenbarger, Ph.D. said...

Thanks, Paolo, for the excellent ideas. Those, indeed, are important relationships--


James W said...

Hi Brett,

I was just wondering if there is any particular reason for picking the 10-yr note vs lets say the 5-yr or the 20yr?


Brett Steenbarger, Ph.D. said...

Hi James,

No, and I do think other rate instruments are worth testing out. I was looking for something on the longer end of the curve; something on the short end would be very interesting.