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When interest rates rise

Wall Street

By Joel Dresang

The Federal Reserve is ending its third round of quantitative easing in October, but to try to get the economy growing at a sustainable pace, it plans to leave short-term interest rates near zero at least until the latter part of 2015.

A rise in interest rates means a fall in bond prices, but what about stocks? Dave Sandstrom, vice president and investment advisor at Landaas & Company, points to data suggesting that stocks should benefit when rates eventually rise.

“When you’re in a rising rate environment, where the yield on the 10-year Treasury is less than 5%, almost in every case, it’s been positive for stocks,” Dave said on a recent Money Talk podcast.

Research by J. P. Morgan Asset Management, shows that since 1963, the Standard & Poor’s 500 index had positive returns (not counting dividends) whenever interest rates rose and benchmark yields were relatively low.

“Studies show that the rate increases don’t hurt stocks if the 10-year is below 5%. We’re at about half that now and have a long way to go,” said Bob Landaas, president of Landaas & Company.

Stocks’ reactions to rising rates depend on the motivations behind the Fed’s actions, Bob explained. At lower yields, the Fed would increase rates as a way of moderating economic growth – to keep inflation in check. At higher levels, Fed intervention is more like cutting fuel to an already overheating economy.

“If you get to the other side, over 5%,” Dave said, “you get a little different story where it’s difficult, and people are more willing to jump out of the stock market and get into those higher-paying, safer assets.”

Historical trends aren’t the only signal that stocks might do well amid upcoming rate increases. So far this year, the stock market has shown little concern or surprise over the Fed’s actions. Even as the Fed has tapered its monthly bond buying since January, the yield on the 10-year has fallen and stocks have climbed.

“The fact that the stock market has been closing at nominal record highs tells you that tapering is a non-event,” Bob said. That would indicate that the Fed’s intervention has not been propping up the stock market. Instead, Bob said, steady earnings deserve credit.

“So the next fight is when we get to a neutral monetary policy, which could take us a number of years,” Bob said. “My guess is it will be so gradual, the increases so imperceptible, that Wall Street will take it in stride.”

Letting rates rise again from next to nothing should take a while because there remains so much slack in the moderately growing economy that inflation is only a remote consideration.

“For years, we’ve been told that inflation was really going to take off,” Bob said. “And now we’re quickly facing a world of abundant capital, abundant labor, abundant capacity. Econ 101 will tell you that will lower stock returns eventually, but it also speaks volumes about where inflation is heading. Inflation can’t go higher right now. If you have abundant capital, abundant labor, abundant capacity, how are people going to raise their prices? They can’t.”

The bumpy road back from the Great Recession has left the Fed occasionally adjusting its targets. Two years ago, it expected to start raising rates by the end of 2014. Then, it set an unemployment rate of 6.5% as a trigger to consider increasing interest. Earlier this year, policy makers agreed to back off on the unemployment threshold.

With the uncertainties of a global economy, it’s possible the Fed could still be kicking the can down the road.

“We could be sitting here having this conversation three or four years down the road before we’re anywhere near some place where the tightening of interest rates really has a significant negative impact on the economy,” said Brian Kilb, executive vice president and chief operating officer at Landaas & Company.

The long, mild recovery also could mean a longer bull market for stocks, Bob said. Analysts have forecast corporate earnings improvements of 11% for all of 2014, as well as for 2015 and 2016.

“We’ve known that recoveries from financial crises tend to be weak. They tend to take forever,” Bob said. “It’s clear in my opinion that as long as the fundamental valuations aren’t stretched, we’ve got some room to run. It could be like the 1990s with the Goldilocks economy – not too hot that the Fed has to aggressively raise rates, not too cold that we have to worry about sliding back into a recession. It could be we’re just about right.”

Joel Dresang is vice president-communications at Landaas & Company.

(initially posted Oct. 2, 2014)

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