INTERMARKET ANALYSIS Interest Rates And Stock Returns by Mark C. Snead
Stocks perform best when interest rates are declining, but rate levels can make a difference. Here's how.
Interest rates can be a dependable component of a stock market forecasting model. Many models use changes in interest rates, in which falling interest rates are considered to be more favorable for stock prices than rising rates are. Many of these applications have weathered the rigors of lengthy real-time testing and are among the favorite tools of market forecasters.
Often overlooked in the relationship between interest rates and stock prices, however, is the forecasting information in the level of rates. Most researchers simply ignore the level because the link to stock returns is not well understood and extracting useful forecasting information can be difficult. Several theories suggest that low rates should be more favorable for stocks than high rates, but direct tests of this simple relationship indicate only a weak link and show little promise as a foundation for building forecasting models.
But it is possible to use a simple analytical tool to extract vital forecasting information from interest rate levels. The process is based on the assertion that interest rate changes and levels should not be tested individually for a link to stock returns but should instead be examined jointly. Joint testing reveals otherwise inaccessible forecasting information contained in the level of rates, but the primary by-product is the ability to produce a much more reliable forecast than is possible using only rate changes.