A ‘new phenomenon’ is helping propel stocks to record highs

Trader Peter Tuchman smiles as he works on the floor of the New York Stock Exchange after the market opening in New York, December 23, 2013.REUTERS/Carlo Allegri

Conventional stock market wisdom suggests that higher rates are bad for stocks.

The thinking is that they increase the appeal of bonds, which may result in investors reallocating from equity into fixed income. Higher debt expenses can also hurt a company’s bottom line, reducing the appeal of its stock.

Deutsche Bank chief international economist Torsten Slok isn’t buying it.

He says that while stock returns and interest rates were once negatively correlated, that hasn’t been true since the early 2000s. Now the two are more closely linked than ever.

The shift boils down to one key driver: inflation. In the 1970s and 1980s, inflation was high, which corresponded to the inverse relationship between rates and stock prices. Now that inflation is flagging, trailing the Federal Reserve’s target, this dynamic has flip-flopped.

“Positive correlation between interest rates and equities is a relatively new phenomenon,” Slok wrote in a client note. “I think inflation will remain under control and near the Fed’s 2% target. As a result, higher interest rates are likely to continue to be associated with higher stock prices.”

Positive correlation between interest rates and equities is a relatively new phenomenon.Deutsche Bank

The peaking of the correlation between stock prices and interest rates comes at a time when the equity market is routinely hitting fresh record highs.

The S&P 500 last reached a record on June 19, and currently sits just 0.4% below that level. The tech-heavy Nasdaq 100 index most recently climbed to an all-time high on June 8, and now is within 1.9% of making a new one.

So while the lion’s share of the credit ultimately belongs to earnings growth — historically the biggest driver of stock gains — traders would be remiss to ignore the strengthening relationship between equities and rates.