Rising interest rates make a different animal of the stock market. Unlike when interest rates are steady or declining, positive earnings (overall for the market, not necessarily individual stocks) just aren’t enough to take the markets perpetually higher.
Many companies are reporting excellent earnings, but the market appears to be somewhat stalled. Taking a look at the recent market performance in Table 1, we can see that 2018 returns have been less than stellar.
Source: MorningStar Index Performance
Higher interest rates create an obstacle for stocks because they raise the cost of what is called the carry trade. A carry trade is a strategy where an investor borrows money at a low interest rate and then turns around and invests the borrowed money in an asset with a higher return. Carry trades can come in many forms, such as a Yen carry trade where investors borrow Japanese Yen at low interest rates and then exchange it for U.S. dollars or another currency that pays a higher interest rate on its bonds. Carry trades also are effective when rates are low and stocks are rising; it makes sense for many investors to borrow money at low rates and buy stocks earning substantial returns.
The problem with carry trades is that the more investors pile into the arbitraged asset, the more the underlying asset price rises, making the carry trade even more attractive. This can create a self-perpetuating cycle and set the stage for periods of irrational valuations based on market euphoria. Such cycles might be followed by sharp market declines or even crashes when the carry trade reverses or unwinds.
Over the past month, short-term interest rates have reached 1.75 percent, and the yield on the 10-year Treasury Bond is approaching 3 percent. This is similar to what happened in other periods of rising interest rates (see Table 2 below).
Some will argue that there are other reasons behind these market declines – and of course there are – however, rising interest rates are clearly a common factor. In order for the market to continue to advance, earnings need to increase at a rate that also compensates for the rise in interest rates.
The Federal Reserve believes it can manage interest rate rises in an orderly manner to keep inflation targets in check without curtailing growth and therefore earnings. As a result, there is certainly no guarantee of a market decline or crash; however, it does mean that strong earnings might not be enough to keep pushing the market higher.