Are Markets Hooked on Low Rates?

Closeup of Interest Rates text in a newspaper

A big reason Wall Street is stuck in bull mode is markets know the Fed has its hands tied on rates.(ISTOCKPHOTO)

Wall Street is booming – the Dow Jones industrial average and the Standard & Poor’s 500 index have both hit all-time highs, and equities have nicely tracked progress in the wider economy. The current economic expansion is 84 months old, nearly twice the age of the average expansion since 1900, which was a mere 46 months.

Unfortunately, there’s a caveat. The booming stock market may be more Federal Reserve-fueled fantasy than bonafide bull rally.

Earnings certainly don’t seem to matter as much as they once did: The price-earnings ratio on the S&P 500 has drifted from below 16 in 2010 to roughly 25 today. Given the sluggish global growth outlook – especially in a post-Brexit world – rock-bottom borrowing costs are having an outsized effect on valuations.

And markets can’t get enough of it.

Throughout the seven-plus year streak of zero or near-zero interest rates in the U.S., central banks throughout the world “have been trying to use low interest rates to inflate asset prices, including stock markets, in the hopes that it will kick-start the economy,” says Matthew Tuttle, certified financial planner and CEO of Tuttle Tactical Management in Connecticut.

The results of that monetary experimentation in the U.S. stock market are unabashedly conclusive: The seven-plus year zero-rate environment has been matched by a seven-plus year rally on Wall Street. Since its lows on March 9, 2009, the S&P has rallied 220 percent, producing a more than threefold gain for patient index investors.

In retrospect, the rush into equities isn’t especially surprising, as low rates force investors to seek returns in places other than fixed income, like stocks. Even older investors and savers, who might normally be drawn to low-risk Treasuries, have started taking to the stock market out of necessity.

Robert Johnson, CEO of The American College of Financial Services, says yields are so unbelievably low that they’ve “essentially forced investors into equities.”

Recently, Johnson says, the yield on 10-year U.S. Treasury bonds fell “below 1.4 percent for the first time in the nation’s history. Contrast that to yields on 10-year Treasury bondsof over 15.3 percent in September of 1981.”

While many investors will will likely gravitate back toward fixed-income holdings when interest rates rise, for now dividend stocks are a better investment, Tuttle says. “When you can make more on a dividend-paying stock than you can on a bond, you really have no choice.”

But perhaps the most troubling reason Wall Street is in unapologetic bull mode is because markets know the Fed has its hands tied on rates. Since easy money policies also encourage companies to borrow cheaply and invest money they might not have otherwise, they give markets yet another reason to rally.

Investors know this, and, anticipating low rates for the foreseeable future, seem to be betting on ultra-low rates by bidding equities higher – despite projected negative earnings growth this quarter.

For the time being, stocks are the only bet in town.

Yellen has her hands tied. Federal Reserve Chair Janet Yellen is stuck between a rock and a hard place right now – it simply doesn’t look like the Fed has the willpower, justification or audacity to raise interest rates any time soon.

But why?

First and foremost, the Fed has two main objectives in its charter: to maintain a reasonable rate of inflation and keep unemployment under control. With unemployment at 4.9 percent, the Fed is doing just fine on the second point. But inflation, which the central bank has said it wants to see at 2 percent, only came in at 1 percent in June.

Raising rates would put further pressure on inflation and would also likely strengthen the dollar as foreign investors poured money into dollar-denominated U.S. Treasuries, seeking yield.

A higher dollar is precisely what U.S. multinationals don’t want to see right now: 48 percent of S&P 500 company revenues come from overseas. Apple (ticker: AAPL), the largest public company in the world, saw 62 percent of its revenues come from overseas last quarter; Alphabet (GOOG, GOOGL), the second-largest public company on the planet, gets 54 percent of its revenue outside of the U.S.

Point being, some of the stock market’s biggest names would suffer materially if the dollar continued briskly rising against the world’s major currencies.

Remember, economically speaking, “the world is flat,” and the Fed can’t just ignore that. Recent events like the Brexit and a string of terror attacks have left global markets on uncertain footing.

Johnson says it would be challenging for the Fed to raise rates in today’s environment: “They don’t want to forestall the tepid economic recovery we’re seeing by raising rates too quickly, they don’t want to contribute to a global economic slowdown and they don’t want to be accused of playing politics.”

Weaning off. So, the stock market is on a seven-year easy money bender and there’s little chance it’ll be taken off the drip any time soon. What’s the end game here? What happens when rates inevitably begin returning to more normal levels?

Peter Nigro, a professor of finance at Bryant University, says markets will simply go into rate withdrawal in much the same way that an addict may struggle to adjust to the sober life after going off the sauce.

If rates swung higher, it “could really hammer equities – especially high-yielding dividend stocks. This is unchartered territory and could lead to problems if the Fed increases rates sooner than current expectations,” he says.

“No matter when they do, however, there will be a reallocation to traditional fixed-income instruments when rates rise,” Nigro says.

Because it is uncharted territory, the good news is that there could be a “soft landing,” where markets gradually adjust to function again on their own without unnaturally low rates acting as a crutch.

For now, though, markets have little choice but to keep happily sipping Yellen’s medicine.

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