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By New_Deal_democrat January 14, 2014 6:28 am
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The changed relationship between interest rates and stock prices


I've written a fair amount recently about the impact of rising interest rates.  For example, they are certainly negatively impacting house sales and consumer refinancing.

But what about stock prices?  How they correlate with stock prices depends entirely upon whether the primary worry is inflation or deflation.

When the primary worry is inflation, interest rates generally move in the opposite direction as stock prices.  Or more finely put, stock performance is above or below average depending upon whether interest rates are falling or rising, respectively:

For example, here is the inflationary era of the 1960s through 1980:

And similarly, here is the disinflationary era of 1981-1998:

In both of those periods, a rise/fall in interest rates led to a relative fall/rise in stock prices.

But now let's look at 1999-present:

The relationship is totally inverted.  For the last 14 years, generally a decline in interest rates has been correlated with a decline in stock prices, and similarly, both have increased in tandem.  In general, this is because the primary fear has been deflation. To the extent deflation looks more (less) likely, interest rates have fallen (risen) and so have stock prices. Only in solid expansion (2004-06, mid 2010-mid 2012) have the two moved in opposite directions, when inflation was more feared.

So long as the Fed continues to stay in tapering mode, it is hard to see how yields fall vey much in the absence of weakness.  Some think that a strengthening economy will push both bond yields and stock prices higher. But could the economy long stand mortgage rates significantly above 5%?

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