The Federal Reserve has hiked interest rates two times this year and plans another two more in the second half. Under the backdrop of a rising rate environment, stock exchange traded fund investors may have to closely monitor certain areas of the market, but overall, higher rates typically correspond with bustling bull market conditions.
Looking at the year-to-date sums of daily equity returns on days when the 10-year yield rose and days when it fell, there is a clear pattern that shows on days when the yield rose, equities tended to rise as well and vice versa on days when the yield fell, Tom Goodwin, senior research director for FTSE Russell, said in a research note.
When yields on Treasuries were moving higher, U.S. equity as represented by the FTSE Russell 1000 tended to outperform both international and emerging market stocks. The iShares Russell 1000 ETF (NYSEArca: IWB) increased 3.0% year-to-date.
The small-cap category would outperform, followed by micro-caps, mega-caps and mid-caps during periods when the 10-year Treasury yields rose. The iShares Russell 2000 ETF (NYSEArca: IWM) gained 8.4% so far this year.
Lastly, looking at investment styles, the Russell 2000 defensive, Russell 1000 defensive and Russell 2000 growth categories were among the best performers when yields on benchmark Treasuries rose.
Related: Major Trends in the ETF Space
Rate Changes & Equity Returns
The positive correlation between rate changes and equity returns this year has been counter-intuitive to many observers. Typically, an increase in rates would lower the value of equities since one would estimate future earnings and “discount” them by dividing by an interest rate that takes into account the time value of money. Higher interest rates also negatively affect corporate profitability by creating tighter credit conditions tighter.
“The reason equities have been positively correlated to rising interest rates recently is because higher rates represent a validation of global growth and are therefore consistent with healthy corporate fundamentals and thus good for stock prices,” Alec Young, managing director of FTSE Russel global markets research team, said in a note. “When inflation is driving interest rates higher it can be more of an equity negative, but lately the interest rate increase has been more about strong US growth and shared international expansion.”
Consequently, the positive correlation between rates and equities this year may be better explained by optimism over global growth.
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