Should investors worry about higher interest rates? The question matters because a rate rise might be looming. The Bank of England said last week that if the economy pans out as expected (a big if, admittedly) then “monetary policy could need to be tightened by a somewhat greater extent over the forecast period than current market expectations”. And monetary policy committee member Gertjan Vlieghe has warned that “we are approaching the moment when Bank Rate may need to rise”.
What would this mean for equities? History suggests maybe not much.
Certainly, this is the message of simple correlations. If we look at monthly data since 1985, the correlation between changes in the All-share index and changes in Bank Rate has been minus 0.09 which is insignificantly different from zero.
A big reason for this, of course, is that stock markets move for all sorts of reasons other than changes in interest rates.
But what happens in only those months when Bank rate does rise?
Since 1985 there have been 34 such months. On average in these 34 months, the All-Share fell by 0.46 per cent, compared with a rise of 0.58 per cent in all months. The All-Share index fell in half of these months, whereas it fell in only 38.4 per cent in all months.
This tells us that the market is slightly more likely to fall than usual when rates rise and does slightly badly on average when rates rise.
A big reason for this is that investors have interpreted rate rises to mean that interest rates will be sustainably higher in future. We know this because gilt yields are more likely to rise in months when Bank Rate rises than they are in other months. And it is the combination of both rising Bank Rate and rising gilt yields that is bad for equities. Of those 17 months when Bank rate rose and shares fell, 11 came when gilt yields rose.
For the same reason, equities are more likely to do badly when Bank Rate rises if sterling rises at the same time: like gilt yields, the pound rises if investors revise up their opinion of future interest rates.
By contrast, equities did OK when Bank Rate rose and gilt yields fell. There have been 15 such months since 1985 and the All-Share index rose by an average of 0.52 per cent in these months, and gave a rise in 10 of them.
Here's the thing. Eleven of these 15 occasions have come since the Bank of England was given operational independence in 1997. Since then, there have been 20 months in which Bank Rate has risen and the All-Share index has risen by 0.25 per cent on average in them, which isn’t far from the 0.36 per cent rise in all months since then. And this gap is entirely due to an 8.2 per cent slump in the market in January 2000, which came when a rate rise coincided with the bursting of the tech bubble*.
Rate rises by an independent central bank, therefore, haven’t been so bad for shares.
One reason for this is that the inflation target reduces uncertainty about the Bank’s objectives and so reduces the fear that one rise will be followed by others. We know the Bank will only raise rates sufficiently to get future inflation down to two per cent - and given how low wage inflation is, this shouldn't require big rises.
A second reason is that the Bank is more transparent than it used to be, and signals its intentions in advance – as indeed it did last week. This means that rate rises, when they happen, are more likely to have been discounted by equity and gilt markets beforehand.
All this suggests investors should not worry very much about a rate rise. Yes, such a move slightly increases the chances of the market falling: since 1997 it has done so in half of the months when Bank Rate rose. But there’s equally a good chance of the market shrugging off a rise.
Sadly, though, history might not be a clear guide here. It’s possible that a rise in Bank Rate from 0.25 to 0.5 per cent would have bigger effects than, say, a rise from five to 5.25 per cent. People are more sensitive to proportional changes than absolute ones: psychologists call this the Weber-Fechner law.When Bank Rate does rise by a quarter point, I dare say somebody will say it has doubled.
Also, it’s possible that ultra-low rates have caused investors to “reach for yield” – to buy equities in the hope of a half-decent income. As rates rise, such investors might want to return to cash and their selling might well depress share prices.
For what it’s worth, my hunch is that these are small risks because rates are not likely to rise by very much – and if markets do show signs of becoming alarmed at the prospect, the Bank of England will seek to comfort them.
In fact Bank Governor Mark Carney did just that this week when he said that rate rises will “be at a gradual pace and to a limited extent.”
Futures markets have heeded this message. They are pricing in a three month interest rate of only 1.2 per cent by then end of 2020 – which would mean that even 13 years after the start of the financial crisis, rates are still far below their pre-crisis levels. In this sense, a few rate rises would represent a change in the weather rather than the climate; the climate would still be one in which real interest rates are negative, reflecting a low rate of trend economic growth.
In fact, I suspect that a much bigger danger for equities – though not an immediate one – would be a downturn in the world economy or stock markets that would render a rate rise unnecessary. In this sense, it is not a rate rise that investors should most fear but rather the absence of one.
Maybe a rate rise is a worry. But it’s not the biggest one equity investors have.
* I say coincided because the S&P 500 also fell that month, which is unlikely to have been due to a UK rate rise.
