How do interest rates affect stock prices?

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In May last year, the RBA followed other central banks with an unexpected upswing in official cash rates. Commentary since then has been all but unanimous that this is bad news for prices of assets, such as stocks and property. For instance, the AFR warned in January: “As interest rates rise, asset prices fall.”

As part of a broader study, I asked Bing AI, Microsoft’s chat bot: in 100 words, can interest rates accurately forecast the stock market? In seconds it came back:

No, interest rates cannot accurately forecast the stock market. Interest rates affect the cost of borrowing and the expectations of investors, which can influence the stock prices and market performance. However, there are many other factors that affect the economy and the market, such as fiscal policy, monetary policy, global events, business cycles, investor psychology, and sector-specific factors. The relationship between interest rates and the stock market is not always inverse or linear. Sometimes, the stock market can rise or fall despite changes in interest rates.

Quick. Decisive (no: on one hand this, on the other …). Nuanced. Well written. But accurate?

To answer my last question, the accompanying chart uses data from the St Louis Federal Reserve Bank to plot the US Federal funds rate (an overnight interest rate which the Federal Reserve controls) against the detrended S&P 500 Index over the last 30 years. Detrending involves removing the long term slope in the Index due to asset price inflation, and so highlights cyclical fluctuations.

This shows that US stocks and official interest rates move roughly together. But interest rates clearly do not lead the S&P 500. In fact, interest rates lag behind. In separate analysis, I have run data in the chart through a statistical package, and stock prices explain about a quarter of interest rates a year later. That is, interest rates lag, not lead, stock prices.

The interest rates-drive stocks assumption is only a simplistic nostrum. It is a dead idea that – like other aspects of Zombie economics – survives only because it is convenient.

In fact, too many assumptions about markets just reflect conventional thought, and have little practical application. This is a major risk for investors.

If investors can reasonably accurately forecast markets (or have someone do it for them), then active investing is sensible. But, if – as decades of academic and analyst research conclude – markets are largely unpredictable beyond a short period of trending, then a different strategy is required. The latter is not just buying the index, but being aware of periods of over- and under-valuation. It also rewards a bit of prudent scepticism.