A Closer Look At The Links For Stocks, Interest Rates, And Inflation

Does history offer a reason to be cautious on the outlook for stocks if inflation and interest rates are rising? Yes, sort of, according to a New York Times article published on Thursday.

Hedging just a bit, the Times piece relates that “it’s long been a truism that higher inflation and its close cousin, higher interest rates, are deadly for stock prices. But in the wake of this month’s correction, and the ensuing recovery in stock prices, some market experts are saying that stocks can continue to rally even if interest rates and inflation rise, as they did Wednesday.”

The bulls are backed by data showing that, during the six periods of rising 10-year Treasury rates since 1988, the Standard & Poor’s 500-stock index has gained an average of 23 percent. Stocks declined in only one of those periods, and then only modestly.

“For the past 20 years, we’ve had a period of strong correlation between stocks and interest rates,” said Brian Nick, chief investment strategist for Nuveen, a TIAA subsidiary.

But “that wasn’t the case for the 30 years before that,” he added. And looking only at the start and end points of periods of rising rates masks considerable volatility in between, not to mention what lies just outside those periods. As rates were rising from 1998 into 2000, for instance, stocks were in one of the biggest bull markets ever, only to plunge after the technology bubble burst.

Nearly all mainstream economists agree that at some point, higher interest rates and inflation hurt stock prices. “Investors are right to be concerned,” said Alan Blinder, professor of economics at Princeton and former vice chairman of the Federal Reserve.

Let’s dig into the relationship between stocks and rates, and stocks and inflation, a bit deeper. In particular, does the one-year change in the 10-year Treasury yield, or the one-year change in the Consumer Price Index, offer any perspective on what the one-year return on the stock market will be 12 months ahead? To investigate, let’s run a regression on the rolling one-year changes for stocks against the one-year lagged changes for the 10-year yield and CPI.