During this recent mild correction in the stock market, interest rates have been coming down. This might seem unusual because lower interest rates are normally thought to be positive for stock prices. However, for most of the past 10 years, when interest rates have declined, so has the stock market.
From a purely theoretical perspective, when interest rates come down it should be positive for asset prices, whether it be for the stock market or real estate. This is because financing costs are dropping. In the last 10 years, lower interest rates were generally positive for markets and, likewise, stock prices did poorly in the 1970s when interest rates rose.
In a low interest-rate environment, as we have seen for much of the past decade, a further lowering of rates has had little impact on the economy. If anything, when rates drop further, the perception is that the economy is worsening, as there is little demand for credit. Some investors fear a Japanese market-type scenario, where interest rates have been kept at extremely low levels and their economy has been dormant for many years.
Comparing the United States to Japan is wrong because we have a more open economy, expanding population growth and greater technological innovation. In addition, while economic growth has been below potential for the past 10 years in the United States, corporate earnings growth, which is the ultimate driver of stock prices, has remained decent.
There continues to be the perception that the U.S. could fall into a deflationary environment, which clearly would be negative for profits. This scenario seems highly unlikely because of the Federal Reserve, which has been proactive in providing liquidity to the financial system. Even though gasoline prices have recently started to retreat, many people would agree that prices for most goods and services are continuing to increase.
As of June 20, the two-year Treasury Bill is at .4%, with the 10-year Treasury yielding 2.95%. At these very low levels, an increase in rates would likely be considered a positive, as very low rates have been associated with greater risk in the financial system. Interest rates would probably have to go to at least 4% for the 10-year Treasury before they would start to be perceived as a negative for the stock market.
The recent decline in interest rates clearly represents greater fear of a slowing economy. One aspect is temporary – supply disruptions due to the Japanese earthquake – and the other is ongoing; the Greek financial crisis, which is primarily a European problem. While economic reports will probably remain disappointing for another month or two, the likelihood of a double-dip recession remains low. Later in the year, expect to see an improving economy with higher interest rates.