Interest rates have tumbled following the monetary response to the COVID-19 economic crisis. This shift is certain to impact investment portfolios, even those without any bond market exposure. Interest rates heavily influence economic activity, capital flows, and retirement planning, so every investor should understand the mechanics of this new reality.

Economic theory and historical data show that low rates bolster stock prices in the short term, and there may even be secondary or hidden catalysts for equities.

Dollar bill with up, down, and percent blocks on top.

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How do interest rates impact the equity market in general?

The Federal Reserve maintains economic stability by controlling the money supply, primarily by engaging in the open market for securities, such as Treasury Bills. For example, the Fed will buy government bonds from banks when a recession seems imminent or reduce the amount of cash banks are required to hold. This causes the amount of money in circulation to rise and encourages banks to lend. Interest rates across the market fall, businesses enjoy cheaper access to capital, and employment is supported.

Expansionary monetary policy supports higher business valuations by stabilizing fundamentals. Consumers are more likely to keep spending, businesses are more likely to keep hiring, and companies with riskier balance sheets are less likely to fall into distressed territory. 

Low interest rates also catalyze equity markets by influencing capital flows. Investors often assume additional risk to generate higher returns in the equity market when bond yields fall. Capital must reside somewhere, and minuscule bond market returns can make stock market volatility seem less daunting if the Fed is explicitly supporting the economy. Higher demand for stocks supports aggressive valuations, pushing markets upwards.

These theoretical effects are supported by historical data. The S&P has averaged 20% returns over the 12 months following a third successive rate cut by the Fed. Some of this can be attributed to Fed action coinciding with cyclical bottoms. Nonetheless, the data is unanimous and meaningful. The Fed's moves in March and April had a predictably positive impact on stock prices. This bump came despite horrible economic news and uncertainty amid an unprecedented employment shock. The Fed's strong stance has emboldened investors and supported economic productivity, which should support stock prices in the medium term.

Where are Funds Flowing Right Now?

Fund flows data confirms the above speculation. Capital is moving away from long-term funds, such as equity mutual funds, and into short-term vehicles, such as money market funds. Equity mutual fund net assets are nearly three times the amount of bond mutual funds, but net outflows from bond funds still outpaced flows from equity funds year-to-date, with especially large flows out of bonds in March.

Capital flows data clearly shows that investors are reacting to uncertainty, but are more likely to engage in equity investments than bond investments. People are looking at tumbling interest rates and choosing disproportionately to either wait-and-see or assume the risk of a volatile stock market. The swelling short-term assets will eventually seek higher returns, and it would seem that investors currently prefer public equities to low bond yields.

Are Investors Being Forced Into Stocks?

Market commenters and economists have speculated over the past decade that a sustained low interest rate environment could cause traditional bond investors to alter their strategy in search of higher-yield substitutes. This created some fear that retirees, for example, would allocate more heavily to dividend-paying stocks or REITs(because of their distribution requirements) to generate income that was no longer achievable with a traditional bond allocation. This could work, in theory, but it would open those investors to a higher level of volatility, which could be disastrous for retirees in the event of required asset sell-offs during down markets, like we saw in March. 

This would certainly be concerning, though it would represent additional demand for equity assets. It would seem, however, that this activity has been minimal. The S&P 500 dividend yield has hovered around 2% going back to 2000. If capital were disproportionately flowing to dividend stocks and away from bonds, then dividend yields should show a more positive correlation to interest rates. Similarly, REITs have lagged the S&P 500 by nearly five percentage points over the past decade. Excess demand for REIT income would likely generate some outperformance of that asset class. Overall, it would seem that retirement planners and income investors are still adhering to sound standards, so don't expect these to lift your stock portfolio higher.

Interest Rates are Have Driven Stock Prices Higher

Falling interest rates have helped buoy the stock market in uncertain times, and a sustained low rate environment should provide continued support for equities over the medium term. As an added bonus, equities are a great hedge for inflation risk that might be the ultimate outcome of Fed policies. The market is still vulnerable to systemic risks to the underlying businesses, especially if unemployment remains high, but the Fed's actions have had an enormous impact on the major indexes in 2020.