Here's a stat that might shock you: A $10,000 investment made in the S&P 500 on Jan. 3, 2022 would be worth only $9,171 today.
Despite this year's 15% year-to-date rally in the S&P 500, the benchmark index is clawing out of the massive hole caused by last year's 18% decline.Meanwhile, over this same period, short-term interest rates have risen from near 0% to over 5%. For stock market investors, this could be an ominous sign.
Let's take a closer look to see why that's the case, and examine what -- if anything -- investors should do about it.
Image source: Getty Images.
What's going on: Short-term rates have skyrocketed
The bond market is complicated. But to grossly simplify what makes interest rates rise and fall, think of it this way:
The Federal Reserve drives short-term interest rates by raising and lowering its key lending rate, known as the fed funds rate. Starting in March 2022, the Federal Reserve has increased this key rate 10 times, lifting it from 0.25% to 5%.
As a result, the yield on a 1-year U.S. Treasury bill -- which closely tracks the fed funds rate -- has soared to 5.4%. That's the highest level since 2000, when a 1-year U.S. Treasury bill yielded over 6%.
1 Year Treasury Rate data by YCharts
Why you should care: High rates lure money away from the stock market
Unfortunately for stock market investors, what happens in the bond market doesn't stay in the bond market, so to speak. As short-term interest rates rise, all sorts of nasty side effects can spring up in other parts of the capital markets -- including the stock market.
That's because money, like water, tends to find its own level. And for investors, high short-term interest rates can act like catnip, drawing money out of volatile assets (like stocks) and luring it to lower-risk fixed-income investments (like bonds and Treasury bills).
The result is that high interest rates often precede a stock market correction, and sometimes even a crash.
Why you should care: High rates often precede a recession
To make matters worse, there's also a high correlation between high short-term interest rates and U.S. recessions. Examine the chart below.
1 Year Treasury Rate data by YCharts
Note that three of the four most recent U.S. recessions (1991, 2001, and 2008) occurred a few months after short-term interest rates peaked above 5%. That's not to say that high interest rates cause a recession, but it certainly doesn't rule it out either.
In addition, higher short-term interest rates alter macroeconomic conditions by making loans more expensive. In turn, the money supply contracts, and consumers and businesses restrain spending, which dampens overall economic activity.
What you can do about it: Don't panic, stay the course
So, with high interest rates already here, should investors should cash out of the stock market and run for the hills?
No, not at all.
While it's true in some respects that warning signs are flashing for the stock market, let me remind you of some of The Motley Fool's key investment tenets:
- Hold though market volatility
- Target long-term returns
In a nutshell, investors shouldn't concern themselves with trying to time the market. Instead, by building a diversified portfolio and holding it for years, you can ride out any bad weather the stock market might conjure up.
Indeed, stock market corrections -- like last year's -- are often a great time to put money to work in the stock market, as fantastic stocks can be bought at a massive discount. So, fear not! Keep saving, keep investing, and let the long-term returns of the stock market work their magic to grow your portfolio.
