By Tom Goodwin, senior research director
So far, 2018 has been characterized by an upward move in interest rates with some volatility around that trend. In March, the 10-year Treasury yield exceeded 3% for the first time in almost five years. This worries some equity investors who view higher interest rates as a threat to equity markets. That threat has yet to materialize, as we will show in this post, and we will also offer some reasons why from our Global Markets Research team.
Charts 2, 3 and 4 look at the daily relationship between movements in 10-year Treasury yields and daily equity returns by global region, cap size and style. The bars represent the year-to-date sums of daily equity returns on days when the 10-year yield rose and days when it fell. There is a clear pattern in these charts: on days when the yield rose, equities tended to rise as well and vice versa on days when the yield fell.
Why the positive correlation?
The positive correlation between interest rate changes and equity returns this year is counter-intuitive to many market participants. A textbook way to price a stock is to estimate future earnings and “discount” them by dividing by an interest rate that takes into account the time value of money. By that methodology, an increase in interest rates would lower the value of equities. Also, higher interest rates often negatively affect corporate profitability by making credit conditions tighter. So what is going on?
For an explanation, we turned to Alec Young, managing director of our global markets research team, who points out that what drives interest rates higher matters a great deal:
“The reason equities have been positively correlated to rising interest rates recently is because higher rates represent a validation of global growth and are therefore consistent with healthy corporate fundamentals and thus good for stock prices," he says. "When inflation is driving interest rates higher it can be more of an equity negative, but lately the interest rate increase has been more about strong US growth and shared international expansion.”
Rate rises that are driven by economic growth are also a signal for positive corporate earnings to come. The level of interest rates can matter, as well. Research has shown that when the 10-year Treasury is below roughly 5%, the correlation with equities is positive, while when the 10-year Treasury is above 5% there is a negative correlation. Historically, when the 10-year Treasury yield has been much above 5% it has been driven by high inflation expectations and at times an overheated economy, both negatives for equities.
In the end this may be a good illustration of the principle that correlation does not prove causation. The positive correlation between interest rates and equities that we have seen this year may not represent one having a direct impact on the other. Rather, they have both been driven by a third factor: optimism about global growth.
 “Guide to the Markets, US 1Q 2017,” JP Morgan Asset Management, December 31, 2016, p. 17.
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