Interest Rates on the Rise: What Does This Mean for the Stock Market?

By on July 11, 2017
Categories: D&Y UPDATES

Global equity markets continued their upward trend in the second quarter with most major indices moving higher.  Foreign stocks led the way again, outperforming domestic stocks by a sizable margin.  Political headlines continued to dominate the U.S. news cycle as the Trump administration tackled controversial issues such as healthcare, tax reform, and foreign policy -with little movement or legislative traction.  Despite the polarized political backdrop, stock market volatility was almost nonexistent during the quarter; the S&P 500 closed more than 1% higher or lower on just two trading days in this three-month period.

Asset class returns for the quarter and year-to-date were as follows:


Asset Class


Quarter 2017



Barclays U.S. Govt./Credit—Int. Fixed Income



S&P 500 Large U.S. Stock



Russell 2000 Small U.S. Stock



MSCI ACWI ex-USA Foreign Stock



S&P Global REIT Real Estate Securities




The Federal Reserve (Fed) raised interest rates for the second time this year.  The Fed’s policy-setting committee raised the interest rate at which banks lend overnight funds to other banks by 0.25% to a range of 1.00% to 1.25%.  The markets were widely anticipating the increase, with the move signaling Fed optimism about the overall health of the U.S. economy.  While indications of an improving economic landscape are usually celebrated by Wall Street, many investors continue to worry about the effects of future interest rate hikes on stocks and bonds.

Importantly, the Fed only determines the target interest rate for very short-term debt, and the current target rate is still very low by historical standards.  As we have observed in the past, it is difficult to accurately predict when the Fed will raise rates and what the longer-term effects may be for both the stock and bond markets.  Additionally, short and long-term rates do not always move in tandem.  In 2005 and 2006, for example, Alan Greenspan’s Fed raised the short-term fed funds target rate from 2.25% to 5.25%, but longer-term rates (as measured by the 10 Year Treasury Rate) declined once the rate increases paused.  Long-term interest rates are primarily shaped by investors’ expectations for economic growth and inflation, not by Fed policy.

Rising interest rates typically mean that borrowing becomes costlier for companies and consumers who need capital.  Conversely, rising interest rates mean those lending money in the market (i.e., savers and bondholders) eventually obtain higher yields.  Indeed, with the recent Fed moves, we are finally starting to see money market yields materially above zero.  In the short term, bond values generally decline when interest rates go up since more attractive yields are available on newly-issued bonds.  For example, if you owned a bond paying 2% interest and newly-issued bonds (with the same maturity and credit rating) are paying 3% interest, your current bond would be less attractive to investors and would need to decline in price in order for the yield to match that of the newer bond.

In managing client portfolios, we keep bond maturities short-to-intermediate term to limit the negative impact of a quick rise in interest rates.  Generally speaking, longer maturity bonds are more negatively affected by rising rates as investors are locked into low rates for longer periods of time.  A return to more normal yields is a healthy development as higher levels of income may be realized in the future, although consumers may feel the pinch in adjustable-rate debt such as credit cards and home equity loans.

It is difficult to find consistent patterns in stock market behavior when interest rates rise or fall.  It is, however, helpful to look at how the stock market has performed historically under both scenarios.  It is probably not surprising that stocks have provided more attractive real returns in a declining rate (less inflationary) environment.  But even when rates rose and higher inflation prevailed over a multi-decade period, stocks still managed to deliver attractive real returns.

  • From January 1, 1950, to September 30, 1981, the 10-Year Treasury note yield rose from 2.32% to 15.84%.  During this prolonged period of interest rate increases, the S&P 500 Index produced an annualized return of approximately 10.79% (with dividends reinvested).  After accounting for inflation, this represented a real return of 6.10% per year.
  • From October 1, 1981, to November 30, 2016, the 10 Year Treasury note yield fell from 15.75% to 2.37%.  During this prolonged period of interest rate decreases, the S&P 500 Index produced an annualized return of approximately 11.59% (with dividends reinvested).  After accounting for inflation, this represented a real return of 8.61% per year.

Treasury and Inflation Rate


Historically, interest rate cycles have had a greater impact on bonds than stocks.  Nonetheless, it is important to note that a bad year in short-to-intermediate term bonds is very different from a bad year in stocks.  Going back to the early 1970s, there have been only two years in which bonds (as measured by the Barclays U.S. Government /Credit Bond Index-Intermediate Term) have had negative returns: 1994 (index down -1.9%) and 2013 (index down -0.9%).  It has been said that a bear market in stocks is like a grizzly bear, while a bear market in bonds is like a koala bear.

Predicting the impact of interest rate hikes on the market is challenging because the outcome depends on the specific economic environment in which they occur (inflation, corporate earnings, taxes, etc.).  While we do not attempt to forecast the future path of interest rates, it seems clear that there is much more room for rates to go up than down.  We purposely construct clients’ fixed income portfolios with the dual aims of protecting capital in a rising rate environment, and hedging equity risk in the event of another sharp stock market selloff.

We hope your summer is off to a great start, and we encourage you to contact our team with any questions or concerns regarding your finances.


Erik H. Nelson, CFP®, CPWA®, Promoted to Director of Financial...

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