The relationship between interest rates and stocks is crucial to understand if you are investing in the stock or bond market. How does the S&P 500 perform when interest rates are rising?
Interest rates and the stock market have an inverse relationship. When interest rates rise, share prices fall, and vice versa. This is a generally believed parading in finance, which we decided to test to see whether it holds up in reality.
This article will show the relationship between interest rates and stocks and backtest different interest rate strategies.
Relationship between interest rates and stocks
Typically, a shift in the interest rate requires a minimum of 12 months to exert a broad economic influence. However, the stock market tends to react much more swiftly to such changes, even anticipating future rate increases. The stock market discounts today what will happen in the future. Sometimes right, sometimes wrong, and sometimes it overshoots both ways.
Gaining insight into the correlation between interest rates and the stock market empowers investors to comprehend the potential impacts of changes on their investments. Most people think these two assets have a negative correlation, but this is not always the case:
Although the mean is slightly negative, since the 2000s, the correlation has become much more positive, so higher interest rates may not necessarily translate into lower stock prices. We decided to backtest this by creating a few different trading strategies.
How does the S&P 500 perform when interest rates are rising – trading rules
The trading strategy we are going to backtest is pretty simple:
- We buy and hold the S&P 500 when the 10-year interest rate level is above its 12-month SMA
- We sell and move to cash when the 10-year interest rate level is below its 12-month SMA
As you can see, we are simply trading based on whether the SMA is above or below the 10-year yield, nothing sophisticated.
How does the S&P 500 perform when interest rates are rising – backtest
For the backtest, we are going to use the S&P 500 index. The data is not adjusted for dividends. Here is the equity curve:
The compounded returns are miserable. Here are some metrics and statistics about the performance:
- CAGR is 1.54% (buy and hold 7.01%)
- Time spent in the market is 51.35%
- Risk-adjusted return is 2.99% (CAGR divided by time spent in the market)
- Maximum drawdown is -51.18% (-52.56%)
If you think about it, It makes sense that the strategy doesn’t work. As we mentioned earlier, when interest rates rise, the opportunity cost of investing in stocks (WACC) is higher. Hence, lots of projects are no longer profitable, and investors turn to treasuries.
However, the inverse is true for all of the above, so how would a strategy that invests in the S&P 500 when interest rates are falling? Here is the new equity curve:
The strategy looks much better now! Here are some metrics and statistics about the performance:
- CAGR is 5.56% (buy and hold 7.01%)
- Time spent in the market is 47.16%
- Risk-adjusted return is 11.78%
- Maximum drawdown is -48.72% (-52.56%)
The CAGR improves dramatically while the time spent in the market drops slightly, and the drawdown is largely the same.
However, this strategy performed much better until the 1990s than during the 2000s and 2010s (when we witnessed quantitative easing).
How does the S&P 500 perform when interest rates are rising – conclusion
In summary, although the theory suggests an inverse relationship between stocks and treasuries, this correlation has become increasingly positive during the last two decades. However, holding stocks when interest rates are falling is far more profitable than buying when rates are rising.