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posted on 31 August 2017

Investing When Interest Rates Rise

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

In my last few articles I described the likely effects of interest rate rises in general, and in the bond market in particular.

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This is relevant now, of course, because interest rates in the United States and elsewhere are beginning to rise after an eight-year period of historic low rates.

And when I say historic low rates, I don't mean just recent history.

In January 2015, 10-year rates dropped to 1.88%, the lowest in history. Considering this, it appears that there is nowhere for rates to go but up.

We've already discussed bonds in those earlier articles. So, what about other asset classes, like stocks, precious metals and real estate? Are there clear relationships between their prices and interest rates?

In a word - no. There are logical arguments about how those assets should be affected by interest rates. But the actual long-term data doesn't bear them out. Below I'll show you what I mean.

Below is a chart from showing the rate on 10-year U.S. treasury notes from 1880 to date. This is a good gauge of U.S. interest rates.

How do rising or falling interest rates affect the stock market?

Compare that to the comparable long-term chart of the stock market below, as represented by the S&P 500 (data prior to 1956 has been reconstructed since the S&P 500 Index did not exist before then).

Comparison of stock prices as interest rates fluctuate.

Note, that while interest rates fell more or less steadily from 1980 (when they were over 15%) to 2016 (where they reached under 2%), the stock market had several bull and bear cycles during that 36-year period. The S&P chart is a logarithmic chart so steep declines in the 1987 bear market (down 35%), the 2000-2003 bear market (down 50%) and the 2008-2009 bear market (down 50% again) don't appear quite as shocking as they were at the time.

Still, it's pretty clear that the two long-term graphs don't share any persistent correlation, whether positive or negative. When interest rates drop, stocks will - do whatever they do. Same thing when rates rise.

So the answer to the question, "What will higher interest rates do to stocks?" is, - nobody knows. History is no guide. All the logical arguments have no real predictive value.

OK then, what about precious metals? Is there anything history can tell us about that?

Well, what history tells us is that it has nothing to say on the matter. Here is the long-term price of gold. In this case, the data only goes back to 1974. It was only in 1971 that the price of gold was allowed to float from its officially-pegged price, so data before that is not meaningful anyway.

How do changing interest rates affect the precious metals market?

Gold peaked at over $800 an ounce in 1980 (a time of historically high interest rates). It then dropped for the next six years, as interest rates were falling. So far, that would indicate a positive correlation between interest rates and gold. But gold then fluctuated in a narrow range between $300 and $400 per ounce for over 20 years, as interest rates steadily fell. So - no correlation during that period. In 2001 gold began a run that went on mostly uninterrupted from 2001 ($400) through 2011 ($1800). It then dropped by 50% over the next few years and has treaded water ever since. All while rates steadily fell.

So, like stocks there is no reliable connection between gold and interest rates.

Finally, let's take a look at real estate. Surely there is a connection there, isn't there?

Well, for prices of housing anyway, not as much as you would think. After rising steadily from 1980 to 2005, housing prices then famously crashed and burned, before eventually bottoming out in 2012. Meanwhile, interest rates dropped for the whole period.

In the end, there is just no telling what the effect of interest rate changes will be on any assets, other than cash in the bank and, to a lesser extent, bonds.

As a long-term investor, the best policy in the face of rising interest rates is - the same as the best policy would be in any other rate environment. That is, to manage your bond investments with an eye on rates as previously outlined; and otherwise, to diversify across several non-correlated asset classes, which could include stocks and/or gold and/or real estate, as well as others. Since they all move to their own rhythms, at almost all times there are some that are doing well even if others are not. Each of those assets must then be managed on its own to its best advantage and according to its own characteristics.

Those principles are the foundation of the ProActive Investing method. We can describe some of the outlines of the program in these short articles. The full details are in the program itself. To investigate further, I invite you to contact your local Online Trading Academy center.

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