Will rising rates bring rising stocks?

CHICAGO Tue Aug 13, 2013 12:47pm EDT

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CHICAGO (Reuters) - For years, the conventional wisdom has been that rising interest rates are no friend of the stock market. A combination of higher costs of borrowing and potential inflation can be a one-two punch for companies and consumers.

But rising rates and stock prices happen more often than investors know, and they can herald brighter economic fortunes in the short term. There are ways to invest in both without getting burned.

This duet has had some off-key news of late because of fears that the U.S. Federal Reserve will curtail its bond-buying program: Bond yields have been rising over the past few months, which depresses bond prices. This has caused a minor shock to income-oriented investors.

The 30-year bond yield has risen from 2.7 percent in June 2012 to around 3.6 percent recently, according to the Federal Reserve. This increase of more than 33 percent hurts those who are not holding bonds to maturity or who invested in long-maturity bond funds.

For example, falling bond prices have driven the plain-vanilla, diversified Vanguard Total Bond Market Exchange-Traded Fund down 2.5 percent in the three months ended on Monday and more than 2 percent year to date, negating its 2 percent yield. The fund tracks an index of most U.S. bonds and charges 0.10 percent annually for management expenses.

This year has been a brighter one for stocks. Rising rates have not put much of a damper on U.S. shares. The Schwab U.S. Broad-Market ETF stock fund has gained about 25 percent, slightly beating the nearly 23 percent run-up of the Standard & Poor's 500 Index. The fund charges 0.04 percent annually to hold most U.S. stocks.

THE LONG-TERM VIEW

Let's assume that this year is quirky because investors are worried that the Fed will soon put the brakes on its easing program but are still sanguine about stocks as the economy continues to grow slowly. Then higher rates will not necessarily put the kibosh on the stock market rally.

Stock prices and bond yields have risen in lockstep a dozen times during the last 60 years, according to Minneapolis-based research firm Leuthold Group. Even when rates have risen during an inflationary period - up 5 percent from March 1978 through November 1980 - stocks rose. In that period alone, the S&P 500 advanced 60 percent.

Overall, bond yields gained an average 1.69 percentage points during the six decades Leuthold studied, while stock prices rose 35 percent. In the most recent bull run, bond yields jumped more than a percentage point, and stocks rose 17 percent through July 5.

If there is a takeaway from the relationship between stock and bond prices, it is that at a certain point investors cease to become optimistic about an improving economy, a crisis strikes or the stock market becomes irrationally exuberant. Although it is nearly impossible to predict when cycles end, holding a mix of stocks and bonds is still a rational move.

Does this mean that a balanced mutual fund makes the most amount of sense in a "tandem rise" environment?

The Vanguard Balanced Index Fund, which holds a mix of 57 percent stocks and 38 percent bonds, has gained 13.6 percent so far this year. It charges 0.24 percent annually for management.

While that is a convenient vehicle for risk-averse investors, separate exchange-traded stock and bond funds offer higher returns. A better approach for long-term investors is to hold individual funds like the Schwab stock and Vanguard bond ETFs mentioned here.

(The author is a Reuters columnist and the opinions expressed are his own. For more from John Wasik see link.reuters.com/syk97s)

(Editing by Lauren Young and Lisa Von Ahn)

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Comments (1)
gunste wrote:
Interest rates should be equal or greater than inflation, so that savers who provide funds for banks do better than negative income.
The Fed’s rate at near zero punishes savers and helps speculators and banks which caused the recession.

Aug 14, 2013 4:26pm EDT  --  Report as abuse
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