Evan Frazier, CAIA
Research Analyst, U.S. Equities
The first quarter of 2021 saw the 10-year Treasury yield nearly double, which had a profoundly negative impact on growth-oriented and higher-valuation stocks. Generally, higher interest rates are expected to lead to lower equity returns and vice versa, all else equal. While the pace of change in the 10-year during the first quarter was enough to rattle investors, data from the last decade does not support an overall negative correlation between the movement in interest rates and equity returns. Since the Global Financial Crisis (“GFC”), monthly returns of the S&P 500 Index and monthly changes in the 10-year Treasury yield have exhibited correlations ranging from modestly negative to strongly positive. This is in stark contrast to the correlations from previous decades, when equity returns and interest rate movements tended to be strongly inversely related, as conventional wisdom would suggest. Roughly 75% of the monthly correlation observations from 1970 to the beginning of the Global Financial Crisis were negative, compared to less than 14% from the GFC to the present day. While many variables likely contributed to this disconnect, the absolute level of interest rates may be the most important factor.
Though it is difficult to precisely quantify the impact, the extremely low yield environment of the past decade has clearly been a boon to stock prices. During periods of low rates, investors tend to shun conservative assets like bonds and turn to equities for yield, otherwise known as the “TINA” effect (i.e., market participants believe “there is no alternative” to stocks in low-rate climates). This phenomenon manifests itself in the form of the equity risk premium (the S&P 500 earnings yield less the 10-year Treasury yield), which has indicated the relative attractiveness of equities for nearly two decades. Low rates also benefit stock price valuations, calculated as expected future cash flows of companies pulled forward to the present day using a discount factor based on the risk-free interest rate. When yields are low, the denominators in those present value calculations are also low, leading to higher valuations. So, despite rates ticking up during various periods in the last decade, stock prices largely continued to rise as rates stayed extremely low on an absolute and historical basis. It is also worth noting that during exogenous shocks like the GFC and COVID-19, both yields and equity prices saw dramatic decreases, contributing to the positive correlation over the last several years.
At higher absolute levels of interest rates, however, the data show a stronger negative correlation between yield changes and equity price movements. The idea that the absolute level of interest rates helps determine the extent to which movements in yields impact equities begs the question: Is there an inflection point at which increases in rates are more likely to lead to diminished equity returns? While there are many factors at play, a quadratic regression on the correlations observed from 1970 through today implies that negative correlations begin at a 10-year Treasury yield of around 5.8%. For investors, this may help allay concerns about the impact of future rate hikes, with the 10-year still below 2%. That said, the era of easy money that has persisted for more than a decade may be drawing to a close, and investors should consider the implications of increasingly restrictive monetary policy going forward.
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