'Don’t fight the Fed' is one of the oldest sayings in finance. It is telling us to hold onto shares right now, because the Fed seems determined to reflate the economy.
Chairman Jay Powell announced recently that it would tolerate higher inflation than it usually does – a statement that has led traders to infer that rate will stay low for years. Futures markets expect no rise until 2025.
They are equally downbeat about the chances of higher rates in the UK. Here, too, markets are pricing in no rise for at least another four years.
All of which poses the question: is the old saying really right? Do low interest rates really predict better equity returns?
History suggests: yes. If we control for bond yields there has been a small but statistically significant negative correlation between the fed funds rate and subsequent annual changes in the S&P 500. This is true whether we look at data since 1970 or just since 1990. There has also been a small but significant negative correlation between Bank rate and subsequent annual changes in the All-Share index.
Lower interest rates, then, have tended to lead to higher equity returns.
From the point of view of efficient market theory, this is weird. Everybody knows the level of interest rates so this fact and its likely effects should be immediately embedded into prices. There should therefore be no link between current rates and future returns.
So why is there? One possibility is that we fail to foresee that our tastes will change: we are prone to what Harvard University’s Matthew Rabin has called a projection bias, a tendency to project our current preferences into the future. Interest rates tend to be low in uncertain times, when we are in or at risk of recession. In such times, investors are averse to risk. Even though they foresee that low rates will stimulate the economy and profits, they don’t also foresee that economic recovery will cause a recovery in appetite for risk. To this extent, prices don’t respond immediately to rate cuts and instead shares rise later as the recovery raises appetite for risk.
We should therefore obey the old saying. We shouldn’t fight central banks and so should be in equities now.
Except for two things. One is that the link between interest rates and subsequent returns, although statistically significant, is economically weak. In the UK since 1990, they have explained less than one-seventh of the variation in subsequent annual returns – and even less in the US. Low rates did not stop UK equities falling in 2015 or 2018, for example.
Also, official rates aren’t the only rates that predict returns. There’s also a statistically significant link between 10-year bond yields and subsequent returns in both the UK and the US, with higher yields predicting higher returns. Alongside the fact that low short-term rates also predict higher returns, this means that the yield curve predicts them, with upward-sloping curves pointing to better returns and inverted ones predicting bear markets.
Again, this contradicts efficient market theory, which says that equities should immediately embody any information about likely future returns of the sort contained in bond yields.
One reason this doesn’t happen, I suspect, is that investors are overconfident. They put too much weight upon their own opinions about future economic conditions and pay too little attention to the message of bond yields. And yet yields embody the wisdom of crowds: when they are low relative to short rates, it’s a sign that investors expect rates to stay low or fall. This is a sign they expect weak economic conditions – an expectation that is correct more often than are economists.
Which brings us to a problem. Although the US yield curve is upward-sloping, with 10-year yields above short-term ones, it is less so than it has been on average since 1970. This is a sign that investors expect rates to stay relatively low and hence that they foresee poor economic growth. Which means weak growth in corporate earnings and heightened risk aversion. These are conditions in which equities might well struggle, or at least face significant risks of doing so.
It’s true that we shouldn’t fight the Fed. But nor should we fight bond markets. Which means that while there is a case for bullishness about equities, this must be tempered with considerable caution.
