Will Higher Interest Rates Push or Punish Stocks?

The answer depends on who you ask.

April 19, 2010

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875788_56596614At some point, interest rates in the major developed economies will have to bounce off their lows. The point is when. Japan proves the exception. Still, forecasters are expecting a higher overnight rate from the Bank of Canada by the summer.

Is it time to worry about the impact (after a decade of low-interest rates, the Japanese stock index has gone … nowhere)? CIBC World Markets suggests that concern is overblown.

“Stock prices respond to a variety of factors, including earnings and growth prospects—not just interest rates”, says Peter Buchanan..”Muddying what would otherwise be a clear inverse correlation between rates and valuations, central bankers historically have tended to take away the punchbowl as these other signals turn from a flashing red to a steady green. It also takes time for the economy—and by extension, sales and corporate revenues—to respond to higher rates, further complicating matters.

“In examining past Bank of Canada tightening cycles for useful guidance, the question then is whether these other positives typically offset the direct bad news from higher rates. History suggests they have in a majority of cases. That’s true of the period immediately before a decision by the Bank to get off the policy fence, and also, though not quite so forcefully, of the months following such action.”

Sounds like some behavioural economics is coming into play. Indeed, that’s part of the reasoning of an earlier – pre-financial crisis – paper by State Street Global Advisors.

“Empirically, in the US, price-earnings ratios tend to fall when inflation accelerates, a phenomenon that has puzzled finance academics,” writes George R. Hoguet. “One approach, which might be characterized as the ‘behavioral approach,’ focuses on investor cognitive bias, and argues that investors commit a mistake when they discount real cash flows with a nominal discount rate.”

That might be called the “uncertainty discount.” As Hoguet puts it: “If inflation is correctly anticipated and if companies can in fact pass on costs of doing business, then nominal cash flows should be unaffected by a general increase in prices. However, as inflation rises, it tends to become more uncertain and a component of price increases may not be properly anticipated by firms.”

The future, as always, is unclear.

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