Should share investors worry about changes in interest rates?
Research shows that, like share prices, changes in interest rates and bond prices are largely unpredictable.[i] It follows that an investment strategy based upon attempting to exploit these sorts of changes isn’t likely to be a fruitful endeavour. Despite the unpredictable nature of interest rate changes, investors may still be curious about what might happen to shares if interest rates go up.
Unlike bond prices, which tend to go down when yields go up, share prices might rise or fall with changes in interest rates. For shares, it can go either way because a share’s price depends on both future cash flows to investors and the discount rate they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the share to fall. However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a share also change. So, if theory doesn’t tell us what the overall effect should be, the next question is what does the data say?
Recent research helps provide insight into this question.[ii] The research examines the correlation between monthly US share returns and changes in interest rates.[iii] Exhibit 1 shows that while there is a lot of noise in share returns and no clear pattern, not much of that variation appears to be related to changes in the effective federal funds rate.[iv]
Exhibit 1. Monthly US Share Returns against Monthly Changes in Effective Federal Funds Rate, August 1954–December 2016
Monthly US share returns are defined as the monthly return of the Fama/French Total US Market Index and are compared to contemporaneous monthly changes in the effective federal funds rate. Bond yield changes are obtained from the Federal Reserve Bank of St. Louis.
For example, in months when the federal funds rate rose, share returns were as low as –15.56% and as high as 14.27%. In months when rates fell, returns ranged from –22.41% to 16.52%. Given that there are many other interest rates besides just the federal funds rate, the paper also examined longer-term interest rates and found similar results.
So to address our initial question: when rates go up, do share prices go down? The answer is yes, but only about 40% of the time. In the remaining 60% of months, share returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up. In other words, there is not a clear link between share returns and interest rate changes.
There’s no evidence that investors can reliably predict changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, this information provides little guidance about subsequent share returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the share market has to offer.
Eugene Fama is a member of the Board of Directors of the general partner of, and provides consulting services to, an affiliate of Dimensional Fund Advisors Ltd. He is a professor of finance at the University of Chicago, Booth School of Business. In 2013, he received a Nobel Prize for his work on securities markets.
Ken French is a member of the Board of Directors of the general partner of, and provides consulting services to, an affiliate of Dimensional Fund Advisors Ltd. He is a professor of finance at the Tuck School of Business at Dartmouth College.
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[i]. See, for example, Fama 1976, Fama 1984, Fama and Bliss 1987, Campbell and Shiller 1991, and Duffee 2002.
[ii]. Wei Dai, “Interest Rates and Equity Returns” (Dimensional Fund Advisors, April 2017).
[iii]. US stock market defined as Fama/French Total US Market Index.
[iv]. The federal funds rate is the interest rate at which depository institutions lend funds maintained at the Federal Reserve to another depository institution overnight.