How Would Stocks Perform When Interest Rates Rise?

The question of how stocks would react when interest rates rise is a very important one for many market participants at the moment. And it’s so for a good reason.

Theory holds that stocks and other asset classes – things like bonds, cash, and real estate – are in a constant jostle for investors’ capital. When interest rates are high, investors shouldn’t pay up for stocks as the alternative (bonds) can deliver a good return. On the other hand, when rates are low, it makes sense to bid up stocks since the alternative (again, bonds) are not capable of generating a decent return.

What the theory also means is that rising interest rates are not good for stock prices.

Interest rates in Singapore are not set by our central bank, the Monetary Authority of Singapore. Instead, they are determined by the market and are strongly tethered to what’s happening in the United States.

And as you may have heard, rates in the U.S. are near all-time lows at the moment and the Federal Reserve, the central bank of the U.S., is looking at bumping those rates higher in the near future.

With all the above as a backdrop, you can now see why the question that’s mentioned at the start of this article is significant.

But, how have stocks actually performed when rates rose in the past? Does the theory I described earlier – that rising rates are bad for stocks – hold water? Here’s what history has given us:

Returns of S&P 500 during times of rising interest rates

Source: Morgan Housel

The chart above comes from data my colleague Morgan Housel had presented in a column he had written for The Wall Street Journal. Over the last 14 times that the Federal Reserve has increased interest rates, stocks actually rose in 12 separate occasions.

Relationships in the world of finance are not always as clear-cut as we’d like them to be. Single variable analysis – the type of analysis where you go “if A, then B” – fail more often than they work. And what we’ve seen in the chart above is a great testament of this.

A Fool’s take

It’s been a wonderful six years for Singapore’s stock market. The SPDR STI ETF (SGX: ES3), an exchange-traded fund which closely tracks the fundamentals of Singapore’s market barometer the Straits Times Index (SGX: ^STI), has steadily climbed by more than 130% since hitting a bottom of S$1.50 at the nadir of the financial crisis on March 2009.

Strong gains like that, coupled with the low interest environment we’re in now, will legitimately lead to fears and questions about what the Singapore market’s going to do next.

But like we’ve seen, it’s hard to say what can happen if and when interest rates do rise. After all, there’s no iron law which dictates that stocks must rise or fall when interest rates climb and both scenarios have in fact happened in the past.

What eventually happens to stocks when rates rise is anyone’s guess. But it’s important to realise just how difficult it is to get that guess right. So, forget about trying to make macroeconomic calls such as these and instead, focus on paying a reasonable price for the shares of quality businesses and then holding them for the long-term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.