Extremes Analysis Of Interest Rates And Stock by Mark C. Snead
This former investment broker explains the relationship between declining interest rates and the lagged effect on the stock market.
Interest rate changes exert a powerful influence on stock price movements. The relationship is a decidedly negative one, with historical stock returns much higher on average with falling interest rates than with rising interest rates. The aspect of this relationship that perhaps most deserves careful analysis is the lagged impact of rate changes on stock prices. After an interest rate change, stock prices do not immediately adjust; instead, they tend to respond in a lagged fashion over periods of days, weeks or months.
Using interest rates to forecast stock prices is promising not only because the two are highly correlated, but also because many theories suggest that interest rate movements should play a key role in equity pricing. Existing theory posits that two influences are responsible for the inverse relationship between rate changes and stock returns. The first is the impact of interest rates on earnings expectations, in that interest rate increases represent increased financing costs to both the firm and the consumer and, consequently, reduce expected future corporate earnings.
The opposite, however, is true for falling interest rates. The second influence is the direct substitution between stocks and debt instruments as the expected returns on the two asset classes fluctuate with interest rates. This substitution seems to be intensifying as the financial markets mature and market participants become more sophisticated. With both mechanisms, rate declines are quite favorable for stocks, while rate increases lead to lower stock prices.