Why Rising Interest Rates Won't Break the Bull's Run

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Rising interest rates don't usually mean good things for economic growth or stock prices. The yield on the benchmark 10-year Treasury note closed at a nine-month high Wednesday and, sure enough, the following day, Freddie Mac revealed the average rate on 30-year fixed-rate mortgages hit its highest level since April 2010. The 10-year then ticked up again on Thursday, closing at 3.70%.

Homebuyers and CFOs alike know that higher rates mean lower borrowing and less spending. That acts as a drag on the economy, corporate profits and, by extension, share prices.

But the yield on the 10-year still has a way to go before interest rates start to hurt the stock market, reckons Jeffrey Kleintop, chief market strategist at LPL Financial. Indeed, for the time being, rising bond yields are actually good news for the stocks.

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"The yield on the 10-year Treasury note has risen by about 1.25 percentage points to 3.65% from 2.39% four months ago," Kleintop writes in his most recent report to clients. "With yields now climbing towards 4%, investors are beginning to wonder when rising interest rates may start to negatively affect stock prices."

At the current rate, the yield on the 10-year note, which serves as the benchmark for everything from credit cards to home mortgages, could reach nearly 5% by the summer, a level last seen in July 2007. But it just so happens that rising yields should mean rising stocks prices, Kleintop says -- at least in the near term.

That because, historically, whenever the yield on the 10-year Treasury was below 5%, stock prices and bond yields rose together, Kleintop notes. It's only when bond yields hit 5% that stocks start to suffer (see chart).



"The reason for the different relationship above and below 5%, and why rising yields are good news for stocks right now, has to do with economic growth and inflation," Kleintop writes. "When yields were rising from a low level, they reflected improving growth and low inflation which was a favorable environment for stocks."

By the same token, when yields were rising above 5%, economic growth was accompanied by higher inflation, which threatened future growth. That hurt the present value of future earnings, which in turn tamped down share prices.

"As economic data continues to reflect solid growth in the coming months, bonds yields and stock prices are likely to continue their climb," says Kleintop. "The tipping point of 5% is still a significant distance away."

For now, the bullish case on stocks can be found in a seemingly unlikely place: a bearish-looking bond market.
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