The Federal Reserve Bank may again raise its fed funds interest rate target and has announced long term plans to reduce its bond holdings.
These developments do not necessarily portend higher interest rates, nor do they point to lower returns for bonds or stocks.
A large body of research shows that changes in interest rates and bond prices are unpredictable. Borrowers and lenders react almost instantly to news affecting rates so strategies that attempt to exploit Fed announcements or other known information are likely to fail.
But what about stocks? Unlike bond prices, which tend to go down when yields go up, stock prices might rise or fall with changes in interest rates. A stock’s price depends on both future cash flows to investors and the discount rate they apply to those expected flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. But when interest rates change, expectations about future cash flows from holding a stock may also change. So, if theory doesn’t tell us what the overall effect should be, the next question is what does the data say?
Exhibit 1 below compares monthly changes in U.S. stock returns with contemporaneous monthly changes in the fed funds rate. If higher rates were followed by lower stock returns, we would expect the points to approximate a line running from the top left quadrant to the lower right. Clearly no pattern emerges.
There is no evidence that investors can reliably predict interest rates, and even if they could, this information would be of little value in predicting stock market returns. The best approach to capturing the returns of the stock market is to stay invested in it.
Also In This Issue:
Revised AIS Sample Allocations
Quarterly Review of Capital Markets
A Customized Portfolio Made Easy
The High Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked by Yield
Recommended Investment Vehicles
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