To tame inflation, the Federal Reserve (FED) has been using their control over the overnight lending rate to member banks to increase borrowing costs. They hope to slow down the economy and bring inflation closer to their 2% long-term target.
With interest rates moving as high as they have in such a short amount of time, there are concerns that this new higher rate environment will cause losses in the stock market. These higher rates are designed to slow the economy, but we must keep in mind that economic growth and stock market returns are not the same.
One way to test this theory is to look back and see how the US Stock Market has behaved in other interest rate environments. In the chart below from Dimensional Fund Advisors, the 1-year annual returns of the US Stock market are plotted against 3-month Treasury yields.
As can be seen in the graph, when 3-month Treasury yields are low, there have been both positive and negative returns associated with the stock market. When yields are in the 4-6% range, the same can be observed. Since no discernable patterns can be made between the two variables historically, there does not seem to be any strong correlation between Treasury yields and stock market returns.
Because Treasury yields don’t appear to have a predictive nature, in this higher rate environment we continue to advise our clients to stay committed to their long-term investment plans.