Fundamentally: When Interest Rates Rise, Stocks Needn’t Fall

Here’s the reality: In May, rates actually rose quite sharply, as 10-year Treasury yields jumped to 2.16 percent from 1.63 percent. Yet the Dow Jones industrial average still soared more than 400 points, to end the month at 15,115.57.

The stock market’s road did become choppy as rates rose. The Dow lost more than 200 points on Friday, for example, but the overall trend remained upward. It just goes to show that while there is a connection between interest rates and the stock market, it isn’t a simple one. When rates rise, said Jeffrey N. Kleintop, chief market strategist at LPL Financial, “it is not the size of the move itself, but the absolute level of yields reached that matters to the stock market.”

Even with the recent uptick, the 10-year yields are only about half of what they were five years ago, during the global recession. And a climb in rates from such a low level may be a tail wind — not a headwind — for stocks, Mr. Kleintop said.

For starters, he said, “it reflects an improving outlook for economic growth and less risk of deflation.” Both are welcome developments to equity investors. Moreover, “it results in losses for bonds,” he said, which may prompt investors to sell those bonds and move money into stocks.

Indeed, over the past month, the average bond fund that invests in long-term government debt has lost more than 6.5 percent of its value, according to Morningstar, the investment research firm. The typical blue-chip stock fund, meanwhile, has gained about 4 percent.

But this is not to say that rising interest rates wouldn’t hurt the stock market at all.

For instance, if rates were to climb enough to threaten the rebound in housing, stocks might start to sing a different tune, market strategists say. But the average 30-year fixed-rate mortgage is still at a historically low 3.81 percent, even though that rate is up since the end of April.

Similarly, climbing rates would threaten stocks if they signaled rising inflation, so that the Federal Reserve might have to curtail its efforts to stimulate the economy. But the most recent reading of the Consumer Price Index showed that prices were up only around 1.1 percent over the past 12 months. That’s down from the 1.6 percent pace of inflation at the start of the year.

So how much would rates have to climb before investors became seriously worried about stocks?

If history is any guide, the threshold is around 6 percent.

Doug Ramsey, chief investment officer at the Leuthold Group, has looked at stock valuations and bond yields going back to 1878. He has found that while there is a relationship between the two, big trouble for the stock market appears to kick in only when 10-year Treasuries are yielding 6 percent or higher.

Theories abound as to why 6 percent seems the magic number. James W. Paulsen, chief investment strategist at Wells Capital Management, argues that 6 percent is important because it reflects the overall economy’s nominal long-term growth rate. “I can see why you’d get a negative reaction if the cost of capital for the market was above the inherent, sustainable growth rate of the economy,” he said.

Mr. Ramsey offers a slightly different explanation. He said that for rising bond yields to hurt the stock market, they would have to be viewed by investors as real competition to stocks. Perhaps at 6 percent, he said, bond yields are high enough that “they are truly thought of as potential replacements or substitutes for long-term stock returns.”

TO be sure, some market watchers say what really matters isn’t the current move in long-term market rates, but what happens with the short-term rate that the Fed controls.

Recently, Ben S. Bernanke, the Fed chairman, hinted that the central bank might soon begin to taper its purchases of Treasury bonds as part of its efforts to stimulate the economy. He did not offer any clues, however, as to when the federal funds rate, now 0.25 percent, might be lifted.

John Stoltzfus, chief market strategist at Oppenheimer Company, noted that whenever the Fed does raise short-term rates, “it could create a jostle in the stock market.” But Mr. Stoltzfus warned investors not to assume that Fed increases would immediately pull the plug on the bull market.

He notes that the last time the Fed started raising rates was in June 2004, when the funds rate was at 1 percent. The central bank proceeded to lift rates 17 times through the end of June 2006. During that stretch, the Standard Poor’s 500-stock index rose 11.3 percent, while the Russell 2000 index of small-company stocks gained 22.5 percent. In the 12 months that followed — while the Fed held rates steady — stocks continued to post double-digit gains.

“What really counts here for investors is, are rising rates crimping the affordability of credit?” Mr. Stoltzfus said. With two-year Treasury notes yielding just 0.29 percent, he said, “I’d argue that we’re far from that point.”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

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