Stocks experience turbulence after interest rate increase

Russell T. Price, CFA®, Senior Economist

October 15, 2018

Markets adjust to higher interest rates

Last week, as the capital markets adjusted to higher interest rates, stocks experienced another bout of turbulence. The Dow Jones Industrial Average dropped substantially on two consecutive days before rebounding modestly on Friday, closing the week 4.3% higher than where it was at the start of the year.  

Not a sign of deeper problems

First and foremost, we do not consider the stock market’s recent short-term turbulence as a sign of deeper economic or stock market problems to come in the near-term.  The U.S. economy is strong, and we believe prospects for further economic expansion are quite sound. Corporate profit growth has also been favorable, and stock market valuations, though somewhat elevated, are not unreasonable or overextended, in our view. 

Market turbulence: normal and expected

It’s also important to remember that periodic pull-backs are a normal and even healthy part of stock market behavior.  From 1945 through 2017, the S&P 500 experienced 77 declines of 5% to 10% for an average of just over one per year. Much sharper declines (of 20% or more) have been historically associated with economic downturns; however, we believe the prospects of a downturn currently remain low.  

Higher rates prompted sell-off--again

A somewhat sudden jump in interest rates took most of the blame for last week’s sell-off, just as they did for the 10.2% correction that the S&P 500 Index experienced in February.  It is important to note, however, that even with an uptick in rates and subsequent stock market volatility, the yield on the U.S. 10-year Treasury note closed this week at 3.17%, versus the 2.40% rate at which it started the year.  While this may seem like a substantial increase, it is very modest from a historical perspective.   

Indeed, higher borrowing costs can act as a drag on economic growth and can squeeze corporate profit margins. More directly, higher interest rates can entice some investors to sell their riskier stocks in favor of bonds, in pursuit of more attractive yields, behavior that can play a role in a short-term, contained correction.  

Forecasters, including Ameriprise, have been anticipating interest rates to rise for the last few years, given that rates have remained stubbornly low for a while now. We believe there is still some room for further increases over the intermediate-term.  Stocks could respond (again) with additional bouts of volatility through this process, but we believe the economy is capable of absorbing higher borrowing costs without losing much of its positive momentum.

Ongoing trade tensions with China, which pose a prominent risk to intermediate-term economic prospects, may have played a role in last week’s market turbulence.  We believe this situation could get worse before it gets better, but much like with rising interest rates, we believe the repercussions are likely to be economically manageable, and that growth should remain sound nonetheless.     

Contact your Ameriprise advisor

Short-term market swings can be very concerning.  Understanding the forces behind such moves, combined with a review of current fundamentals, however, can help long-term investors avoid the mistake of making investment decisions based on short-term emotions.