Interest Rates Raise Pressure


The target federal funds rate — the interest rate the Federal Reserve targets for overnight loans between banks — has hovered near 0% since the end of 2008, helping anchor bond yields and borrowing costs at historically low levels. But while that short-term lending rate probably will not rise anytime soon, those who cannot borrow at the fed funds rate have begun to feel the pinch.

The 10-year Treasury bond yields 2.49%, up from a low of 1.66% in early May, while the average rate for 30-year, fixed-rate first mortgages has risen to 4.51% from 3.35%. 

The Federal Open Market Committee hasn't presented a hard target date for raising the fed funds rate, instead suggesting it will raise rates when unemployment drops to pre-crisis levels. However, 15 of the 19 members of the committee don't expect the fed funds rate to rise before 2015.

While the risks of higher interest rates to bond investors are obvious — bond prices tend to fall when rates rise — stock investors will also feel the impact. In the near term, higher rates tend to be bad for stocks as well.

Since 1955, the S&P 500 Index has averaged three-month total returns of 1.9% — 2.5% during periods when 10-year Treasury yields fell and 1.4% during periods when yields rose. In general, the larger the rise or fall in rates, the more extreme the returns.

However, with 12-month holding periods, the effect of interest-rate changes on stocks was less predictable. The S&P 500's average 12-month return was 7.8% — 8.5% during periods of falling 10-year Treasury yields and 7.2% when yields rose. But as the table at right illustrates, stocks can do quite well even during periods of modestly rising rates.

Dow Theory update

While it's hard to see interest rates trending anywhere but higher in the years ahead, rates are just one of a myriad factors that affect the stock market. And sometimes bond yields rise because investors expect the economy to improve, which tends to support corporate profits and dividends. Stocks themselves have been trending upward, with the diversified Dow Industrials jumping to new all-time highs and the economically sensitive Dow Transports rallying to within 1.2% of their May closing high of 6,549.16.

While the Industrials' move to new highs is encouraging, it will take a similar feat from the Transports to reconfirm the Dow Theory's bullish tack. A failure by the Transports to reconfirm the Industrials' new highs would be worrisome, especially if followed by a breakdown below the June lows of 14,659.56 in the Industrials and 5,990.79 in the Transports. For now, with the Dow Theory in the bullish camp and attractive stocks available at reasonable valuations, investors should hold at least 95% of their portfolios in stocks.

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