By Ashley Bleckner, CFP®, MA
One of the most important tools the Federal Reserve has available is the ability to control the federal funds rate. The federal funds rate is the interest rate paid by banks to borrow money from the Federal Reserve Bank. Essentially, it’s the cost to banks to borrow money. This increased expense to banks for borrowing has a ripple effect; the banks pass on this cost to their own borrowers/customers.
The Federal Reserve meets this month. Since the financial crisis, the Fed has used this tool 3 times to incrementally increase rates. Will they increase interest rates again? If so, how does it affect you and your family? There is a direct inverse relationship between interest rates and bond prices, that is, when interest rates rise, bond prices tend to decrease (and vice versa). But, when interest rates go up, do stock prices go down too?
Unlike bond prices, stock prices do not follow a behavioral trend in a changing interest rate environment. For stocks, it can go either up or down because stock prices depend on a number of factors, including future cash flows and the expected rate of return (referred to as the discount rate). When interest rates rise, the discount rate may increase, which in turn could indicate the price of stocks will fall because future cash flows are being discounted at a higher rate. However, it is also possible that when interest rates change, expectations about future cash flows also change.
So, if theory doesn’t tell us what the overall effect should be, the next question is: what does history tell us? When examining the correlation between monthly US stock performance and changes in interest rates, there is a lot of noise in stock returns and no clear pattern. Not much of the variation appears to be related to changes in the federal funds rate. For example, in months when the federal funds rate rose, stock returns ranged from –15.6% to 14.3%. In months when rates fell, returns ranged from –22.4% to 16.5%.
The research demonstrates that when interest rates go up, stock prices sometimes go down… about 40% of the time. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was also evident when examining all months, not just those in which rates went up.
What does this tell us? There’s no evidence that investors can reliably predict changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, this information provides little guidance about subsequent stock returns. And, an investment strategy to exploit these sorts of changes isn’t likely to be a fruitful endeavor. Research demonstrates that avoiding short-term predictions or strategies and staying the course increases the likelihood of capturing stock market returns.