Are Lower Interest Rates Good for Stocks?

The short answer: it depends.  Ever since 1981 or so, stocks and interest rates have mostly been inversely correlated — which makes sense. There are a number of obvious ways lower rates should benefit equities.

For instance, lower interest rates mean cheap leverage, which can amplify corporate earnings and thus increase stock prices.  They are also thought to divert some would-be bond investors to potentially higher-return alternatives such as stocks.  And, they can benefit the general economy by reducing consumers’ interest expense, resulting in greater disposable income.

Rate declines instigated by the Fed as it attempts to stimulate the economy through quantitative easing are considered positive for stock prices.  But, lower rates can also reflect increased fear in the markets — a sign that investors are pulling money from stocks and piling into bonds.

Looking at the chart below, we can see that many sharp declines in TNX (10-yr treasury yields) accompanied strong rallies in SPX (S&P 500), particularly between 1981 and 1998.  But, two other sharp interest rate declines, from 1999-2003 and 2007-2008, preceded significant market crashes.2016-08-01 TNX v SPX 0657Note that the two worst crashes as well as a number of significant corrections occurred when TNX dropped below trend — either the red trend line connecting the 1986, 1993 and 1998 lows or the resulting falling red channel bottom.

So, what does it mean that TNX has recently plunged below the channel bottom while stocks are on the rise — a divergence of the type that accompanied past corrections?  It’s an important question, as other patterns are arising that smack of the calm before the storm.

I’ll be posting throughout this week about a new analog [what’s this?] that, while in its early stages, could portend a significant move in the markets.

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