Ignore The Hype: Here’s What Interest Rates Are REALLY Telling You About The Future Of Stock Prices

Posted On May 17, 2018 2:37 pm

At the start of the year the 10 year US Treasury yield (proxy for long-term interest rates) was 2.48%. As I write this that yield stands at 3.1%. That 0.62% increase in 4.5 months is above the “red line in the sand” that many analysts, such as French investment bank Société Générale warned would spell trouble for overvalued stocks. And indeed the market is now mired in a correction, having fallen 10% off its January 26th all time high and currently sits 5% below that level (and 5% above its low). Many investors worry that rising rates are bad for stocks, thanks to the financial media’s popular bumper sticker meme of “rates up, stocks down”. However here’s what the media, and most investors are missing.

Stop Thinking Short-Term And Focus On The Fundamentals

It’s true that very low interest rates can help elevate stock valuation multiples, because if bond yields are very low (and even negative on an inflation adjusted basis) then stocks appear more attractive by comparison. Especially high-yield stocks such as REITs, utilities, and MLPs. Indeed when the 10 year Treasury yield hit its all time low of 1.36% right after Brexit many of these stock sectors were in a bubble fueled by yield starved investors looking for “bond proxies”. However to understand why the “rates up, stocks down” meme is wrong you have to stop thinking in the short-term and instead take a fundamental, long-term view. One that starts by understanding the important differences between stocks and bonds.

When an investor lends to the US government for 10 or 30 years, it’s because they are looking for a risk free asset class that is guaranteed to generate some income but most off all not lose money. Bonds have a fixed coupon payment they make twice a year (the interest rate). Unlike stocks they don’t represent an ownership stake in anything, and their payout never rises. This means that the biggest risk to a bond holder is inflation. After all if inflation is high than the principal repayment you are guaranteed to get upon maturity will be worth far less. In fact over a 30 year period an average inflation rate of 2.4% means that the real buying power of your repaid principal will be cut in half.

This is why bonds, especially long-term bonds, are so sensitive to inflation. Well if the economy is weak, meaning growing very slowly or not at all, then there is almost no inflation. More importantly a weak economy means there is very little opportunity cost to not invest in alternatives like stocks. But when the economy is strong? Well then demand for money (say from companies to fund expansion) is high and interest rates rise. That is also partly because a strong economy means that inflation is likely to go up. As a result bond investors need to demand a higher yield in order to offset this higher inflation and preserve the purchasing power of their investment.

This means that you can use bond yields to actually determine what the bond market, which is driven by the largest financial institutions in the world, think about the state of the US economy. That’s by using the 10 year TIPS or Treasury Inflation Protected Securities break even price. This is the difference between 10 year inflation linked Treasury bonds and their regular non inflation adjusted counterparts. The difference is a good proxy for long-term investor inflation expectations. Which in turn is a good proxy for what the bond market, which is dominated by giant institutions like pension funds, insurance companies, and mutual funds, thinks about the long-term prospects for US economic growth.

Source: St. Louis Federal Reserve

As you can see between 2013 and 2014 long-term inflation projections were around 2.1, indicating good but not excessive US economic growth expectations. It was also right at the Federal Reserve’s long-term inflation target. Then in 2015 and 2016 growth expectations dimmed and long-term inflation expectations fell. In fact some even began fearing a recession was coming.

Well since early 2016 those fears are gone and now inflation expectations are back to where they were earlier. Or to put another way the bond market is bullish on the US economy. That’s because job growth is strong, wages are rising (slowly), and corporate earnings are booming thanks to both tax cuts but also strong consumer spending. That’s not just in America but globally. In fact US retail sales for April were up 4.7% year-over-year and the 3 month average is 4.6%. In addition the IMF has raised its global economic growth forecast (yet again) to 3.9% for both 2018 and 2019.

This is why US multinationals are reporting such strong growth in revenue (13.1% in Q1 2018). That in turn is fueling 26% EPS growth for the S&P 500. That must all be due to tax cuts right? Actually according to Thomson Reuters tax cuts account for just 11.6% of that, with 14.4% of that earnings growth purely due to stronger sales and higher margins. What about next year? Well according to FactSet Research analysts are expecting that tax reform will have negative impact on EPS growth (due to high bar to clear to generate growth). But guess what? Expectations are for 10% EPS growth anyway. Why? Because the US and global economy is that good. Or to put another way the fundamentals of the market (earnings,cash flows, and dividends) are strong and expected to remain so for at least the next 18 months.  

I must be crazy right? Because if what I’m saying is true then it sounds like rising interest rates, as a proxy for stronger economic growth, should be good for stocks. Well when you actually look at the historical data that’s precisely what it means. 

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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