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Higher interest rates and a stronger economy

In addition to pulling the economy out of the ditch after the 2008 crisis, low interest rates have helped to fuel the current stock market rally that dates back to early 2009. Prevailing wisdom is that higher rates will choke off the economy and eventually end the rally. The return of volatility in recent weeks to the stock and bond markets is raising fresh questions about the relationship between interest rates and stock prices. If history and logic offer any insights, today's pundits may be wrong about an inevitable connection between the end of quantitative easing and lower stock prices.

The last time the Fed started raising rates was in June of 2004, when the Fed funds rate was at 1 percent. Bit by bit, the Fed raised rates to 5.25 percent, ending that round of tightening at the end of June 2006. During that stretch of two years, the S&P 500 rose over 11 percent and continued to climb for the next year while the Fed held rates steady. In September of 2007 the Fed began easing rates in response to the unfolding banking crisis, eventually reaching .25 percent, where the Fed funds rate has been since December of 2008.

Fast forward to the present. The economy is grinding through a slow recovery.  As the Fed begins to contemplate an end to quantitative easing, good news for the economy in the form of lower unemployment, lower inventories and a sustained rebound in housing are often taken as bad news for the stock market and we sell off. Conversely, indications of weaker than expected GDP growth or a weaker dollar are sometimes cheered by the markets as proof that stimulus is still needed. The last few weeks' price gyrations are showing that the markets may be anticipating a change in policy by the Fed. 

If the recovery is in fact sustainable, the Fed's version of emergency resuscitation will have been effective.  Ultimately, stock prices are driven by the economy and investor perceptions of the current and future business environment. The ability of companies to make profits and pay dividends are proof of a healthy economy. Indeed, earnings on S&P 500 companies have been improving consistently since mid-2009.  In the same vein, modestly higher interest rates are one of several positive consequences of a growing economy. Just ask any saver.

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Bob Van Wetter

A graduate of Dartmouth College, Bob is a cofounder and Chief Operating Officer of Northstar, an independent, registered investment advisor. Bob divides his time at Northstar between portfolio management, equity research and spending time with clients. Reach him at bvanwetter@northstarinvest.com.

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