Jerome Powell, Chair of the Federal Reserve recently signaled the Fed’s readiness to cut the target for short term interest rates (federal funds rate) at the next meeting on July 30th and 31st. According to the Federal Reserve Bank of Atlanta, as of 7/19/19, the federal fund futures markets predict a 96.79% chance of a rate cut. Assuming, a rate cut occurs as expected, what can we say about potential stock returns over the short-term?
First, it’s helpful to consider why interest rates should impact stock prices. Generally, there are three ways one would expect interest rate changes to impact stocks prices.
- Financing costs – If interest rates fall, the cost of debt financing for companies would also fall, thus reducing interest expense and increasing profit. Maintaining a stock price’s valuation ratio (price divided by earnings) would therefore imply a higher stock price.
- Discount Rate – Ultimately, a stock price is determined by the cumulative expected future cash flows discounted by some amount. That discount rate is driven partially by interest rates. A decline in interest rates should reduce the discount rate and drive up stock prices.
- Substitution Effect – Changes in interest rates can change the demand for stocks vs bonds by making one or the other more attractive to investors. If bond yields decline along with interest rates, stocks become a more attractive substitute in investment portfolios, thus increasing demand for stocks.
So, given all these fundamental drivers of stocks prices related to changes in interest rates, can we utilize predictions about interest rate changes to actively position stock portfolios? The surprising answer is there is little evidence in the data that this relationship holds.
According to research from Dimensional Fund Advisors, the statistical relationship between interest rate changes and stock returns is close to zero. In the table below, we can see data related to changes in rates at various points in the yield curve. Of note is that the  R2 for each rate category is close to zero demonstrating essentially no historical explanatory relationship between interest rate changes and stock returns.
Table 1: Regressions of Monthly Fama/French Total US Market Index Returns on Contemporaneous Monthly Bond Yield Changes. (Source: Dimensional Fund Advisors)
This will be important to keep in mind as the July Federal Reserve meeting approaches at the end of the month. There will be much in the way of media commentary on how stock prices will be affected one way or the other by what the Federal Reserve chooses to do regarding the federal funds rate. When you see the headlines, you will already know that the answer.
Bond yield changes are obtained from the Federal Reserve Bank of St. Louis. The sample period is from August 1954 to December 2016 for regressions using effective federal funds rate, and from February 1962 to December 2016 for regressions using 1-, 5- and 10-year Treasury constant maturity rates. Please see Index Description for more information regarding the index shown. R-squared (R2) is a statistical measure that represents the proportion of the variance for a dependent variable that’s explained by an independent variable or variables in a regression model. Whereas correlation explains the strength of the relationship between an independent and dependent variable, R-squared explains to what extent the variance of one variable explains the variance of the second variable. So, if the R2 of a model is 0.50, then approximately half of the observed variation can be explained by the model’s inputs. – Source – Investopedia  Fama/French Total US Market Index Provided by Fama/French from CRSP securities data. Includes all US operating companies trading on the NYSE, AMEX, or Nasdaq NMS. Excludes ADRs, investment companies, tracking stocks, non-US incorporated companies, closed-end funds, certificates, shares of beneficial interests, and Berkshire Hathaway Inc. (Permco 540).Results shown during the periods prior to each index’s inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.