In yesterday’s post, What Falling Interest Rates Mean For Portfolio Investors, we asserted, “The current generation of investors are accustomed to stock panics driving money into bond funds, but if this dynamic were to flip around, and panics in low yielding long term bond funds caused a rebalancing feedback driving stock prices lower, it would be a new era of rising interest rates.” We thought it would be appropriate to back up this assertion with the data, so we used the “Start Date” and “End Date” chart controls in Portfolio Workstation to pull the returns for VFINX and VUSTX, and how correlated their close prices were for every year going back to 1987.
VFINX is the Vanguard S&P 500 mutual fund and VUSTX is the Vanguard long term treasury mutual fund. These were chosen since the inception dates are far older than the ETFs we might normally look at, SPY and TLT, and include most of the current long term bull market for interest rates.
The data in the following table does support our assertion. In every case where there is a substantial negative year for either stocks or bonds, they will show a sharply negative correlation, but most of the time they are correlated because they are both usually moving higher. This behavior has become so ingrained in investors that we feel compelled to call out that the long grind lower in rates is a key driver for this behavior.
One factor we didn’t touch on in yesterday’s post is that US Treasury interest rates are an important input for how stocks are valued. Consider why a CFO cares about the price of shares that have already been sold to the public. Most companies are carrying a large debt load that they roll over in the corporate bond market. A company’s market cap is a buffer for lenders who are looking at the chance of bankruptcy over the lifetime of their loan. This means that the market cap is sort of like a credit score for companies, where higher stock market valuations translate to lower interest rates demanded by lenders, thus lower operating costs for the company, and more profits for investors.
This feedback loop won’t always operate favorably for investors, but it has since 1987. What we were calling out to watch for was a year going forward where we see negative returns for both stocks and bonds (and a positive correlation during that time). For us, this would signal a potential secular market change from falling rates to rising rates. We don’t mean to imply such a market change is imminent, just that buying long term bond funds at 2% as part of a portfolio strategy is a completely different proposition then buying them at 10%.
* Daily close prices over the year were used for correlation
** 2015 numbers are only through 4-6-2015