Stocks and Rising Interest Rates

[RobGiles]

I know we’re not in the business of prediction, and the trend in global stock markets is clearly bullish still, but the change in direction of bond yields suggests the risk is clearly to the upside (for interest rates) and that has me worried about its effect on the equity bull market. The old adage
‘Bull markets don’t die of old age, they are killed by higher interest rates’ is in the front of my mind.

Whilst I’m not about to override any system rules, I’m interested to know if a) anyone shares the same concerns, b) does it change any capital allocation decisions to momentum or bull market systems and c) has anyone seen any research to suggest that equity markets can rally when the interest rate cycle changes from expansionary to tightening?

Also is anyone thinking they need to develop more systems that cope / excel in more volatile markets in preparation for a change in market direction. As a disclosure I am still fully invested.

[ScottMcNab]

I have never tried it but it would be interesting to see if any of the charts in markets/us economy could be overlaid as an entry/exit filter or for changes to position sizing in regard to those points Rob

[LEONARDZIR]

Rob,
On the other hand, rising interest rates which are still historically low are a reflection of the robust economy in the US. This is the first correction of 3% or more in the last 444 days in the US market. Finally increased volatility should be great for our mean reversion systems.

[RobGiles]

Scott McNab wrote:

I have never tried it but it would be interesting to see if any of the charts in markets/us economy could be overlaid as an entry/exit filter or for changes to position sizing in regard to those points Rob

Yes it would Scott, although I’m unsure how to do it. I wonder if Donald Dony (Canadian economist/ trader who presented at Noosapalooza) has one?

[RobGiles]

Len Zir wrote:

Rob,
On the other hand, rising interest rates which are still historically low are a reflection of the robust economy in the US. This is the first correction of 3% or more in the last 444 days in the US market. Finally increased volatility should be great for our mean reversion systems.

Hi Len, yes, you make a good point and I seem to remember reading somewhere that at the initial stages of an interest rate tightening cycle, equities can be relatively unaffected, but it can be a different story in the later stages. My view though is that individuals and businesses globally have geared themselves on extremely low rates and if rates were to go from 2 – 4% (a doubling of the funding costs for households and businesses) there will be some pain. Yet by historical standards we would still be at very low rates. If that were to happen in Australia, the mortgage stress would be acute.

Like you I see all this resulting in increased volatility and hence the need for systems that can generate profits from that.

[RobGiles]

One of the daily market wires I’ve read for the past 5 years had some interesting comments to make about rising interest rates resulting in increased volatility:

So getting back to the sharp correction last week, I think it was more about the market reacting to the sudden break from the ultralow volatility levels, and acclimatising to the reality that interest rates need to rise.

It was a volatile week and placing this in perspective with history, the S&P 500 Index’s 14-day relative strength index – a technical gauge of the magnitude and speed of price movements – has swung 57 points lower over the past two weeks. Bloomberg highlighted last week that this was the biggest such reversal for the S&P500 in history, with the next biggest swing being a 47-point reversal during the 1987 crash, thirty years ago. There is a generation of market participants that have not experienced this much volatility.

So it will take markets some time to accept that interest rates need to rise, and that volatility is not going back down to the low levels we saw during the goldilocks era. But recover the markets will.

Last week reminds me a little of 1987, where the US economy had a strong corporate sector and solid economic fundamentals, and volatility levels peaked early after October that year, and recovered relatively quickly. US interest rates were also much higher back then. We believe that markets reached a climactic selloff last week and the correction of 10% that we were looking for is now in place.

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