Interest Rates, Economy, and the Stock Market

There’s a commonly-held economic assumption that lower interest rates lead to higher stock markets. The support of this wisdom is a few more commonly-held assumptions:

• Stock market prices are driven by anticipation of higher corporate profits.
• Rising interest rates stifle credit (loans), make it harder for companies to source funds for expansion.
• Rising interest rates make fixed-income yields more attractive compared to investing in stocks and direct investment in companies.
• With less expansion and investment, growth in corporate profits plateau.

And the list continues carrying the same logic.

In recent years, evidence seems to indicate otherwise–about the relationship of interest rates, the economy, and the stock market. We can take some publicly available information, these charts courtesy of the New York Fed website and draw the relationships ourselves.

Three groups of data: Stock Market Indices, Short-Term Interest Rates, and Non-Farm Payrolls (being a measure of economic output). Here are the charts (updated as of May 2008):

If you look closely, seems economic output and stock market prices are indeed correlated as people assume–but the surprise is that both are also correlated with interest rates as well.

Higher rates = higher economic output = higher stock prices?

I think the key is understanding what drives short-term rate movements, which are largely tied to monetary policy of the Federal Reserve. Although the intricacies of what drives Fed policy are to lengthy to discuss in this post, one thing should be basic to readers is that Fed policy, and by association, short-term rates, move in response to two conflicting concerns:

Inflation vs. Recession

Inflation is a concern since high prices lead to higher production costs, which can depress economic growth. Recession is a fall in economic output. The two problems are not mutually exclusive either, since both can exist simultaneously in a phenomenon called Stagflation.

Personally, I view interest rates as the trigger point. Rates fall when the Fed eases monetary policy in response to a demand for liquidity. Case in point: the recent subprime crash, where banks and investment houses, suffering from losses in mortgages, savagely needed liquidity, forcing them to sell their mortgage investments, causing further losses.

The Fed will usually ease rates act to stem the liquidity crisis, but will eventually stop once the crisis has abated, and subsequently raise rates to arrest inflation. In the past this has coincided with a rebound in the economy, and consequently coincided with higher stock prices.

The point I’m driving at is the statement Correlation does not imply Causation. Just because two things happen together does not mean one causes the other. The common logic of lower interest rates leading to better economy and markets is a causal statement–which would have been disastrous to follow in the past. I’m merely pointing out that once rates have stopped falling, the economy and markets seem to recover in the same period.

Fortunately we are in another situation to test the relationship now. Fed has been lowering rates to arrest the crisis but now with inflation and higher prices pressuring the economy the easing might stop. The period following it should be a good one for stock markets if the relationship shown by the above charts continues to hold.