Last Updated on June 19, 2022 by Quantified Trading
The lower the interest rates, the more attractive it is to own risky assets like stocks, gold, and Bitcoin. This relationship is at the cornerstone of the financial theory. In this article, we do a backtest to look at the relationship between interest rates and stocks.
What happens to stocks when interest rates go down? Our backtest reveals that when rates go down, stocks perform well, just as the financial theory says they would.
The relationship between bonds and stocks
It all comes down to interest rates. As an investor, all you’re doing is putting up a lump-sump payment for a future cash flow.
The basic assumption in financial theory is that when interest rates go down, stocks go up. This is, of course, not an absolute relationship, but a pretty general assumption.
The logic is simple: The lower the interest rates, the more appealing it is to own risky assets like stocks.
Why is it like this?
It’s because bonds are less risky than stocks:
Bonds are less risky than stocks
If a company goes bankrupt, the company needs to be winded down in an orderly fashion. But the law has a preferred order of who gets what is left first, and bond owners are always paid before equity owners. Thus, equity (stocks) are riskier than bonds because you are more likely to lose money.
And when interest rates go down, it gets less appealing to own low-risk assets like bonds.
However, interest rates vary – a lot. We have witnessed a 40-year bull market in bonds (when bonds go up the interest rates are falling), and stocks have performed very well. But we anticipate a higher correlation between bonds and stocks when inflation goes up.
What happens to stocks when interest rates go down?
Let’s do a backtest so we can look at what happens to stocks when interest rates go down. We backtest the following hypothesis:
We are long stocks (SPY) when bonds (TLT) are above the N-day moving average, and we sell when it’s below the moving average.
When TLT closes above its 20-day moving average, we buy SPY at the close. When the close of TLT closes below its 20-day moving average, we sell SPY at the close.
SPY is the ETF of the S&P 500 and TLT is the ETF of the US 20-year Treasury bonds.
Why do we do it like this? Because when TLT goes up, it means that the interest rate is going down. The price of the bond and the yield are often inverse, please read what happens to stocks when bonds go up.
Our backtest uses an optimization where we test the N-day moving average from 5 days up to 100 with 5-day intervals (in total 20 backtests). The results look like this:
Column one shows the result of using a 5-day moving average (being invested in SPY when TLT is above its 5-day moving average), column 2 shows a 10-day moving average, etc.
The fourth column, which contains the profit factor, is pretty high at all moving averages except for the shortest.
If we backtest the 15-day moving average, the equity curve looks like this from 2003:
What happens if we flip the strategy? Please read this article:
What happens to stocks when interest rates go down? Conclusions
The financial theory states that there is an inverse relationship between stocks and interest rates. As we have explained in this article, this means that stocks and bonds go up at the same time. When interest rates go down, stocks go up.
Our backtest shows what happens to stocks when interest rates go down: stocks perform better than any average period when long-term Treasuries go up, exactly as financial theory says it would.