Among the factors that influence the performance of stock markets, few have an impact as much discussed as interest rates. When rates rise, the cost of money rises and, in theory, investors should move towards safer assets such as bonds. However, when rates fall, shares appear more attractive again.
However, there can be a notable difference between theory and practice. In this article we will try to quantitatively analyze the relationship between interest rates and stock market performance. We will evaluate how the latter have behaved in different monetary policy scenarios, to understand if there really is a measurable connection between the trend of interest rates and that of stock markets.
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Interest rates and the stock market: theory and reality compared
Interest rates are one of the main tools through which central banks influence the economy. When inflation tends to rise or the economy shows signs of overheating, monetary authorities intervene by raising rates, with the aim of slowing down demand and reducing pressure on prices. On the contrary, in periods of economic weakness or recession, monetary policy becomes expansionary: rates are lowered to stimulate investment, consumption and credit.
These movements, despite being driven by macroeconomic logics, have a direct impact on the financial markets. An increase in rates tends to make stock investing less convenient than bond instruments, which offer higher returns with limited risk. At the same time, higher rates mean higher costs for companies, reducing future earnings and valuations.
However, the link between rates and markets is not always immediate. Stock markets often anticipate the decisions of central banks, reacting not so much to the level of rates themselves, but to monetary policy expectations. In other cases, underlying economic growth is strong enough to offset the negative effect of a rate hike.
Figure 1. Stock markets and interest rates
S&P 500 Strategy Assumptions Based on Interest Rates
To concretely analyze the link between interest rates and the stock market, we have built a basic strategy applied to the S&P 500 index, represented by the SPY ETF, one of the most used globally to replicate the performance of the American index.
The idea is to observe how a $100,000 portfolio invested in SPY would have performed depending on the direction of interest rates. To do this, we use the Federal Funds rate (FEDFUNDS), the main reference rate set by the Federal Reserve, updated monthly.
A 12-month simple moving average is calculated on the FEDFUNDS, which represents the average trend in rates over the last year. We will subsequently analyze two distinct scenarios:
- the portfolio’s behavior during periods when rates are below their moving average;
- and that in periods in which rates are higher.
In this way we will be able to evaluate whether the stock market tends to perform better in contexts of low rates or, on the contrary, manages to maintain good growth even in phases of more restrictive monetary policy.
Performance from 1992 to today: is it better to invest with high or low rates?
The analysis covers the period starting from 1992, the year from which both the monthly data of the SPY ETF and that of the Federal Funds rate are completely available. All results are calculated on a monthly basis, assuming reinvestment of returns.
Figure 2 shows the equity line of the portfolio invested only in the periods in which interest rates are lower than their moving average. Figure 3, however, shows the performance of the portfolio in periods in which rates are higher than average.
The benchmark, represented by the buy & hold on SPY, shows an annual compound return (CAGR) of 8.6%, with a maximum drawdown of 56%. The strategy applied to periods of rates below the moving average records a CAGR of 3.2% and a maximum drawdown of 61%, while in periods of rates above the moving average the yield grows to 5.2%, with a more limited drawdown of 27%.
It is natural that both versions show lower returns than buy & hold, since the strategy does not always remain invested: during the phases in which rates do not satisfy the condition, the capital remains in liquidity and does not generate returns.
Observing the two curves, we can see how the portfolio associated with higher rates showed more constant growth over time, while the one associated with low rates showed lateral phases and deeper drawdowns.
Figure 2. Results by operating long on the SPY when rates are below average
Figure 3. Results by operating long on the SPY when rates are above average
Diversifying in “weak” periods: portfolio test with Treasury Bonds and Gold
From the previous results it emerges that the periods in which interest rates are below their moving average are those in which the stock market has historically performed worse. Instead of simply remaining in liquidity during these phases, it may be interesting to evaluate the use of capital in alternative assets, potentially more suitable for low interest rate environments.
For this reason we have built a second version of the strategy, in which the capital is invested in a balanced way (50/50) between two instruments representing different asset classes:
- TLT, the ETF that tracks long-term US Treasury Bonds, often considered a safe haven in times of economic slowdown;
- GLD, the ETF that tracks the price of gold, has historically been used by investors as a hedge against uncertainty.
In practice, when rates are below the moving average, the portfolio is positioned on a balanced combination of TLT and GLD, while during periods in which rates are above the average, the investment remains entirely on SPY.
The objective is to evaluate whether diversification on alternative assets during “weak” phases of the stock market can improve the overall risk/return profile of the strategy.
Performance of the combined strategy and improvement of the reward/risk ratio
Compared to the previous test, in this case the time frame is narrowed to 2004, the year from which the data for all the ETFs considered (SPY, TLT and GLD) are completely available. This allows us to maintain the consistency of the comparison, but over a more limited period.
Figure 4 shows the performance of the portfolio compared to the buy & hold on SPY.
The results show how this version of the strategy provided a CAGR of 9.4% versus 8.5% for buy & hold, with lower volatility (14% versus 19%) and a maximum drawdown reduced to 29% versus 56% for the benchmark.
Overall, the portfolio performed better than the simple buy & hold, offering more regular growth and containing the most pronounced phases of losses. Although this is an extremely simple strategy, the result suggests that alternating different assets based on the interest rate regime can help improve the overall efficiency of the investment, without sacrificing long-term performance.
Figure 4. Comparison between buy and hold and portfolio.
Conclusion: Exploit the link between interest rates and the stock market in systematic trading
The analysis shows that the relationship between interest rates and the stock market is far from linear. While theory suggests that stocks tend to benefit from low rates, the results show that, in practice, periods of rising rates are when the S&P 500 has performed best.
This behavior can be explained, at least in part, by what several economists have observed: interest rates tend to be mean reverting, that is, to move around an equilibrium value in the long run. In other words, when rates are high, it is likely that they will begin to fall in the following months, and vice versa, when they are particularly low, they will tend to rise over time. Investors, aware of this dynamic, could therefore anticipate changes in the monetary cycle, pushing stock markets to react before monetary policy itself changes.
The extension of the strategy with the introduction of TLT and GLD in the “flat” periods improved the risk/return profile, also demonstrating how diversification between asset classes can mitigate the less favorable phases of the stock market.
As possible future developments, several directions could be explored: further diversifying the equity side, for example including indices from other geographical areas; use alternative instruments during periods of low rates, such as short-term bonds; or change the distribution of weights between instruments, abandoning the static 50/50 distribution in favor of more dynamic logics based on volatility or recent performances.
There are many avenues to explore, but for today we can stop here: a simple quantitative test has already shown us how the link between rates and markets is more complex, and more interesting, than theory suggests.
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Until next time,
Andrea Unger