THURSDAY JANUARY 7, 2010

Are higher rates good for stocks?

Interest rates at the long end of the maturity range have been rising. The 10 year Treasury note has seen its yield rise from 3.18% on October 1, 2009 to 3.84% today. Is this good for equity investors? Is it possible that equity investors should be hoping for higher interest rates? Maybe.


Typically, equity investors hate rising interest rates. The cost of capital rises for both investors and the companies they are buying. Over time, the higher rates inhibit economic growth. But in the current environment, rising interest rates may be a good sign. It really depends on why interest rates are rising. There are two schools of thought on rates today, one good for stocks and one very bad. 

 

First, the really bad one.   This scenario has long-term interest rates rising due to the onset of inflation. The market begins to perceive that inflation is a problem and that the Federal Reserve is asleep at the switch. The Fed maintains its accommodative policies even as the dollar plummets and commodity prices jump. Long-term interest rates begin to increase rapidly. Some would suggest this is already happening. The higher Treasury rates would cascade into other loan rates. The commercial and home real estate markets turn sour again, defaults increase, foreclosures rise and the banking industry recovery is reversed. Credit Crisis Part II and the economy enters the feared “double-dip” recession. Obviously, equity markets would suffer mightily under this scenario.

 

The other school of thought is a happier one. In this case, interest rates begin a slow and methodical rise as the economy begins to show stronger growth. The real estate markets show continued signs of improvement. High productivity continues, job creation returns, the unemployment rate begins to recede and inflation remains subdued. The Fed announces that solid economic growth will allow it to remove its “accommodative policies.” Corporate earnings skyrocket with economic growth, more than compensating for the higher rates and the markets boom. Happy day for equity investors!

 

It will be interesting to watch the markets in the early part of 2010. I suspect that markets will gyrate as the economic statistics swing from one school to the other. Perhaps the most important note is that under either scenario, interest rates move higher. This may or may not be good for equity investors, but it is certainly bad for bond investors!

POSTED AT 1899-12-30 10:36:00.0

KEN ENTENMANN, CFA
SENIOR VICE PRESIDENT AND
THE DIRECTOR OF INVESTMENT MANAGEMENT SERVICES

Ken is a Senior Vice President and the Director of the Trust and Investment Services at Alliance Bank, N.A. He has 23 years of investment experience and oversees the management of assets totaling $1 billion. He holds a B.S. in Applied Economics and Business Management from Cornell University and an M.B.A. from the William E. Simon Graduate School of Business Administration at the University of Rochester. He has also earned his Chartered Financial Analyst designation. He is a member of the Executive Committee of the Trust Division of the New York Banker's Association. He is also a director of the Central New York Community Foundation.

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The opinions expressed here do not represent the views of Alliance Financial Corporation and Alliance Bank, N.A. This communication is not an offer or solicitation for the purchase or sale of any security, is for general informational purposes only and does not provide personalized investment advice. When making personal investment decisions you should consult your investment adviser or rely on your own research. Copyright 2008.