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Interest rates have rocketed since the election. In the past month, the yield on the 10-year U.S. Treasury note – a bellwether debt security for long-term interest rates – is up 60 basis points to post the largest monthly spike in three years.
Interest rates rose into the Federal Reserve’s most recent FOMC meeting, on Dec. 13 and 14. Fed officials did the expected at the meeting and raised the range on the federal funds rate 25 basis points to 0.75%-to-1%. After the meeting, Fed Chair Janet Yellen hinted that three more increases could be in store for 2017.
Could be, but not guaranteed. Traders in fed funds rate futures contracts are betting only two increases will occur next year, with each increase being no more than 25 basis points. The range on the fed funds rate would move up to 1.25%-to-1.5% from the current 0.75%-to-1% by the end of the year. (The average over the past 30 years is closer to 5%.)
Many investors are worried, nonetheless, and for good reason: Rising interest rates can work against stocks. Alternatives, like fixed-income investments, become more attractive in comparison. Debt and equity costs can rise if a company needs to tap capital markets to expand or maintain on-going operations. That’s the negative.
But rising interest rates can also engender positives.
GDP Forecast
Higher interest rates frequently correlate with higher economic growth. On that front, gross domestic product (GDP) growth for the third quarter posted at 3.2% on an annualized rate – the highest quarterly growth rate in two years.
What’s more, the Organization for Economic Cooperation (OECD) in its latest forecast says that U.S. GDP will grow 2.3% in 2017 (for the full year) and 3% in 2018, the highest full-year GDP growth rate since 2005. (For the record, Trump targets 4% annual GDP growth.)
The trend in corporate earnings should further bolster optimism. S&P 500 corporate earnings were up 6.6% for the third quarter. Of the reporting S&P 500 companies, 72% reported earnings above the mean estimate, according to FactSet data.
FactSet goes on to tell us that fourth-quarter S&P 500 earnings will be up 3.2%. Should FactSet’s forecast prove accurate, it will mark the first time the S&P 500 has seen year-over-year growth in earnings for two consecutive quarters since the fourth quarter of 2014 and first quarter of 2015.
The Yield Curve Reflects Good News
I find more reason for optimism in the yield curve – the plot of the yields on 3-month through 30-year Treasury securities. The yield curve has steepened since the election, and this is good news.
The slope of the yield curve has borne a consistent relationship with economic activity. The yield curve has predicted all U.S. recessions except one since 1950. Recessions, as you would expect, correlate positively with bear markets. When the yield curve flattens, or inverts, a recession usually looms and so does a bear market.
That’s not the case today. The yield curve is just the way we should like it – progressively higher with each maturity and upward sloping to the right. When the yield curve steepens, economic growth usually follows.
Yield Curve Slope
With that said, one tidbit of data tempers my enthusiasm. I refer to investor optimism.
The American Association of Individual Investors Sentiment Survey showed its 13th largest three-week rise in November. Of those surveyed, 44.6% are bullish on the outlook for stocks over the next six months, and only 29.2% are bearish. The historical average is 38.5% bullish and 30.5% bearish. A month ago, these figures were flipped, with a plurality of investors being bearish. Negative sentiment, which we don’t have, correlates with rising stock prices.
Positive News for Stock Prices
Taken in aggregate, though, the news over the past month has been positive for the outlook on stocks as we head into 2017.
So, don’t fear rising interest rates. They’re still extremely low from a historical perspective, and they will remain low from a historical perspective. As long as rates remain low and as long as the yield curve trends positively to the right, stock prices have a decent chance to trend positively to the right as well.