Interest Rates and Stock Prices: The Relation Isn’t That Simple

It’s convenient to blame this week’s market tantrum on interest rates. Convenient, but simplistic. The more complete answer is that nobody knows what drives short term volatility. There are many possible explanations that don’t fit neatly into a two word sound bite. Any or all of them may have contributed to the turbulence.

Interest rate changes by the Fed may be part of the equation. But, remember several times this year an interest rate increase by the Fed was greeted as a sign of confidence in a healthy economy and stock prices react favorably.

I respectfully disagree with the President. The Fed isn’t acting crazy. There are all kinds of good reason to increase interest rates, and they have long telegraphed their intentions. That information should have been factored into market prices.

Investors may have come down from their tax cut sugar high. The spike in economic good news was at best only partially the result of the tax cut. In fact, the economy has been steadily improving for the decade following the unfortunate events of 2008-2009. Perhaps investors concluded along with many economists not present in the Oval Office that a one time growth spurt of that magnitude was not sustainable. The next step in that thought process is that perhaps they had been too optimistic in their forward view of profits.

When stock prices get ahead of fundamentals, a correction is inevitable. This is in fact a very good thing. It keeps market prices reasonably rational over the long haul, and is absolutely necessary for the markets to function. But, the timing of these corrections remains a mystery until after the fact.

Stock prices were on the high side of normal and after a long bull market, some investors may simply be taking some of their chips off the table.

While current profits are robust, future guidance by some companies indicate that they might not increase as quickly or might even level off. For instance, the sale of smart phones may be limited by a saturated market or phones lasting longer before replacement. That doesn’t mean that Apple will fail, but profit growth may decline or level off.

You may have noticed a certain amount of political turbulence in Washington with one or more branches up for grabs. Investors might be playing it cautious until the mid term elections sort some of that out.

A trade war that threatens to spiral out of control can’t possibly be making investors feel better about future profits or economic growth. There are anecdotal signs that it’s already eating into profits of some companies, and predictions by many economists call for almost a 1% cut in GDP growth rate. At very best it makes planning exponentially harder when companies project capital spending.

Dollar strength is somewhat related to interest rates in that higher rates tend to strengthen our currency. A strong dollar is a mixed bag for US industries. But for those like Boeing or Caterpillar that depend on foreign sales for a large part of their revenue it makes their products less competitive.

With very low unemployment and some industries having trouble attracting workers, investors may be imagining an inflationary pressure. Labor costs will certainly eat into profits.

If in fact the Saudi government murdered an American based reporter in their consulate in Turkey, repercussions in the Administration’s Mid East policy would certainly impact global oil prices. It’s hard to factor that in, but a significant cause for concern.

A universe of computer trading untouched by human hands but dictated by mysterious algorithms may have had amplified the volatility.

Finally, investors may just be feeling grumpy. Keynes’ Animal Spirits may be out to play. Who knows?

The Invisible Hand is constantly tinkering with market prices as it must. Lots of factors guide it. Nobody knows for sure what motivates it at any particular moment.

However, if you are a Talking Head with 15 seconds of air time to opine on what just happened, just look profound and mutter: “Interest Rates”.

By | 2018-11-28T20:35:42+00:00 October 12th, 2018|Blog|

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