The US Federal Reserve recently decided to maintain interest rates at current levels during their September meeting. However, the central bank also indicated that another hike should arrive in December.
Taking a broader view of the general interest rate environment, those signposts indicate that the current trend in the US is still upward.
For traders from a variety of niches in the financial market, the interest rate direction in the US is an important data point, and in many cases can even help guide ongoing portfolio management and strategy.
What's important to remember is that the direction of interest rates is arguably just as important to follow as the rate itself. Central banks from countries throughout the world routinely use interest rates as a powerful method of managing economic policy.
When economic conditions are deteriorating, interest rates are often moved lower to encourage additional borrowing, which in turn can help stimulate the economy.
During an economic recovery, interest rates are then "normalized" (i.e. moved higher) to ensure that the low rates don't create conditions in which the economy is likely to overheat from hyperinflation (i.e. surging demand for goods, which leads to higher and higher prices).
All this means that the trend in interest rates is also highly indicative of the trend in the underlying economy. When rates are rising, economic conditions are typically improving, and vice versa.
It's therefore possible to categorize different periods in the market’s history by the trend in interest rates and study the relative performance of asset prices during these periods.
Lucky for us, a recent episode of Closing the Gap - Futures Edition does exactly that.
Specifically, the guys from Closing the Gap wanted to better understand whether the two different interesting rate environments (rising and falling) showed any differences in the relative performance of US equities versus Foreign equities.
The findings presented on this episode reveal several definitive patterns and may help traders better understand the current trading environment.
The team examined historical trading data from 1970 to 2017 and then categorized each month according to the trend in interest rate movement. Next, they measured the performance of both the S&P 500 and a basket of foreign equity markets in each of these periods (rising rate months vs. falling rate months).
The graphic below summarizes the findings:
As you can see in the slide above, rising and falling rate environments have clearly affected the relative performance of the S&P 500 versus foreign equity markets.
According to the data, when interest rates are rising, the S&P 500 has performed significantly worse than foreign equities. On the other hand, when interest rates are falling, the S&P 500 has done far better than foreign equities, on average.
When thinking about the relationship between confidence and risk, the above data does seem rational. If economic conditions are improving, investors are probably willing to accept more risk due - one reason why foreign equities likely perform better when interest rates are rising.
On the other hand, when economic conditions are deteriorating, investors often flock to “safer” assets. During these periods, stocks in the United States are clearly preferred over those from foreign/emerging markets.
This information can help traders optimize their portfolios and strategies based on the current interest rate environment - or at least better understand how underlying stocks from different regions might perform.
We encourage you to watch the entire episode of Closing the Gap - Futures Edition when your schedule allows.
If you have any questions or comments, please leave us a comment in the space below, or reach out directly via firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.