Can Interest Rates Predict Stock Market Performance?

Much talk has been made recently about rising interest rates.  One of the most followed gauges of interest rates is the rate paid when the US government borrows money.  This information is regularly available and acts as a proxy for interest rates in the economy.  The government routinely borrows money at differing time intervals, e.g., 2 years, 5 years, 10 years, 30 years, etc.

Depending on the marketplace, each time interval likely has a different interest rate.  Interesting, these interest rates have historically been a signal to stock investors as well as bond investors.  Allow me to clarify:

As of 4/26/18, the 2-year Treasury Bond interest rate was 2.48%

As of 4/26/18, the 10-year Treasury Bond interest rate was 2.95%.

Therefore, the government is paying an extra 0.47% to borrow money for 10 years rather than for 2 years.

Three years ago, the difference between those two yields was 1.50%.

So what?

Well… the difference in bond yields may act as a pretty solid indicator of future returns in the stock market.  If there is only a small difference between the two (less than 1%) it generally implies we are in the later stage of the economic cycle, and future stock market returns may be muted.  Take a look at the following numbers for the S&P 500 since June, 1976, (the earliest data set I could readily find). 

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Ideally, investors like to see steeply sloping yield curves with a big difference between short term and longer term rates.  The implications of interest rates today suggest once again that the upward trend in the stock market over the last 10 years may be running out of steam.  Returns may be muted over the coming year, and the odds of a negative outcome may increase.  Investors may be wise to look for returns in more defensive areas of the investment world and scale back on their stock exposure.