Weekly Observations for 2/2/2018 — Interest Rates and the Stock Market

Here are some thoughts on interest rates and the stock market as we close out the week. There are fewer links than usual, as these are my own ruminations on the changes being observed in the economy and markets.

–  As of this afternoon, the U.S. stock market (S&P 500) has declined a little over 3% since it’s peak on January 26th, with half of that decline occurring today. This is the first even slight decline in a very long time.

–  The bigger news is the recent rise in interest rates. 1-year Treasuries now pay 1.89% after years of near-zero short-term rates, and 10-year Treasuries have risen 1% in the past 12 months to 2.78%. These are significant movements in an economic environment where persistent low rates have spawned unprecedented levels of debt and investment in risk assets.

–  Higher rates are good news for conservative investors seeking income, albeit at the expense of current value for investors holding lower yield bonds.

–  However, for stock investors, higher rates introduce the risk that capital will move away from risky assets as “safe” returns become more attractive. It is possible the recent downward movement in stocks has been in-part precipitated by this rise in interest rates.

–  Higher rates also raise the risk of investing in businesses (and governments) that have dramatically increased their debt levels while relying on low rates to sustain the interest payments.

Based on current investor sentiment and positioning, there are a few possibilities from here:

–  There has been a persistent “buy-the-dip” mentality in place for many years now, typically resulting in a swift rebound whenever stocks sell-off. Will it happen again? Probably, but…

–  If there isn’t a quick rebound, stocks could easily continue to sell off from the recent parabolic rise, which could also put a pause on rising interest rates as a “flight to safety” occurs. Or perhaps even reverse the rise in rates, if Dr. Hunt’s thesis is correct.

–  Ever since the advent of the “Greenspan Put”, the Federal Reserve has stepped in mitigate severe market downturns. In recent years, they have stepped in with Quantitative Easing (QE) programs even after only modest declines. While each successive QE has been less effective in stimulating the economy, they have successfully prevented a stock market correction. Will it work again? Probably, but…

As a patient value-investor, I welcome any decline in prices — in any asset class — as an opportunity to invest with a reasonable expectation of a return on and of our capital going forward. This is an unprecedented time in market history, with many things to observe and consider as we chart a path to build and preserve wealth.

I am looking forward to next week. Until then, enjoy the Super Bowl!