Stock markets move higher as interest rates stay low

Nothing seems to be able to keep global stock markets from rising ever upwards. Not US housing market woes, nor inflation concerns, nor Chinese overheating. And stock markets are likely to continue climbing higher as long as global interest rates stay low.

The Dow Jones Industrial Average added 2.8 percent last week to hit a new record of 12,961.98. The Standard & Poor's 500 Index rose 2.2 percent to 1,484.35, a six and a half year high and just three percent away from its all-time high of 1,527.46 attained on 24 March 2000.

In the process of achieving these gains, the US markets shrugged off a 4.7 percent fall in China's stock market on 19 April, the Dow actually hitting another record high on that day, and then following up with another one the very next day.

It was a similar story in Europe, where the Dow Jones STOXX 600 Index gained 1.6 percent last week to hit 389.26 while the Dow Jones Euro STOXX 50, an index for the countries sharing the euro, rose 2.3 percent to 3895.00.

Asian stocks also rose last week despite a region-wide tumble on 19 April set off by signs of overheating in China as the country released a report showing that the economy grew 11.1 percent in the first quarter and inflation accelerated to 3.3 percent in March. The Morgan Stanley Capital International Asia-Pacific Index added 0.8 percent last week, its third straight week of gains.

What is behind the resilience in global stock markets?

Better-than-expected earnings have helped. According to Bloomberg, about 66 percent of companies in the S&P 500 that have reported first-quarter results exceeded analysts' estimates. Projections for earnings growth in the first quarter for S&P 500 companies have improved to 6.2 percent from 3.1 percent a week ago.

Meanwhile, Europe and Asia have benefited from strong economic data, the negative reaction to China's growth notwithstanding. Mergers and acquisitions have also boosted markets, especially in Europe.

Ultimately, however, stock markets are being supported by low interest rates. Low interest rates not only support the real economic activity that provides the basis for stock valuations, they also fuel stock market buying directly and thus boost stock prices.


US interest rates have clearly been low and supportive of US stock markets. Long-term interest rates in the US have been drifting downwards since the middle of 2006 after the last interest rate hike by the Federal Reserve in July that year. In fact, the yield on the 10-year Treasury note, at about 4.7 percent, has practically drifted back to the level prevailing back in mid-2004 when the Federal Reserve started its tightening cycle, and is significantly lower than the earnings yield on the S&P 500 of about 5.5 percent.

Central banks in Europe and Japan are still in tightening mode, but with the Federal Reserve on the sidelines, do not seem to be making much of an impact on global interest rates on their own. In fact, the yields on 10-year government bonds in the euro area are still around where they were in the middle of last year despite five rate hikes by the European Central Bank since then.

In the meantime, the Bank of Japan's tightening has been very gradual -- only two rate hikes in the past year. As a result, Japanese interest rates remain low in absolute terms, helping to feed carry trades which, no doubt, are keeping interest rates elsewhere low as well.

Little wonder then that global stock markets remain buoyant. Investors know the old saying: Don't fight the Fed. But since the Fed is away, it is time for investors to come out and play.

But for how much longer? Investors have to be careful projecting low interest rates indefinitely. Although interest rates have generally merely fluctuated around current low levels over the past few years, they can sometimes sustain a trend in one direction long enough to have a disruptive impact on markets.

Remember that back in early 2005, rate hikes by the Federal Reserve were also failing to move longer-term interest rates up. However, towards the end of that year, yields on the 10-year Treasury note began to climb, eventually rising more than a percentage point and culminating in a sell-off in risky assets in May-June of 2006.

So the current bout of ECB and BoJ tightening could yet make a significant impact on markets.

And then, there is the fact that some economists are still thinking that the next move by the Federal Reserve is not a rate cut, as most other economists expect, but a rate hike. This could happen if inflation stays stubbornly high while the US economy recovers later in the year, as is widely expected. If the Federal Reserve does resume rate hikes, markets could see some interesting times indeed.

However, a rate hike by the Federal Reserve is an unlikely prospect for the time being -- not when the US economy is still in a soft patch. This means that stock markets are likely to stay resilient in the near future.