Janet Yellen’s walked-back comments on interest rates show how sensitive markets are to any hint of policy shift

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You know markets are on edge when an entirely predictable observation about interest rates sends investors scurrying for the exits.

U.S. Treasury Secretary Janet Yellen set off the mini-panic on Tuesday when she suggested in a taped interview that – gasp – interest rates “will have to rise somewhat to make sure that our economy doesn’t overheat.” Bond yields surged and tech stocks fell, only to reverse course after Ms. Yellen walked back her remarks later in the day.

The turmoil demonstrates a couple of important facts about today’s market.

First, today’s investors are an unusually anxious lot. Many have ridden stocks’ epic recovery over the past year and are now scanning the horizon for threats that might endanger their gains.

Second, people really don’t have a good grasp on this interest rate thing.

Mix anxiety and confusion together and this week’s interest rate turmoil is likely to be the first of many such episodes to come as investors try to get a handle on what rising rates will mean to sky-high stock prices.

To keep your cool over the months ahead, it may pay to look deeper at the relationship between interest rates and stock valuations – or to be more precise, at the complete lack of relationship between them.

Despite what many investors think, rising interest rates do not automatically mean stocks will trade for lower multiples of their underlying earnings. Conversely, falling interest rates do not inevitably lead to higher stock valuations.

The historical record is clear: Changes in interest rates had remarkably little impact on the price-to-earnings ratio of U.S. stocks between 1872 and 2020, according to a recent analysis by Nicolas Rabener, managing director of FactorResearch, an investment analysis firm in London.

The typical P/E ratio for U.S. stocks was 15.8 over this century-and-a-half period, Mr. Rabener found. The multiple barely differed between periods in which the 10-year Treasury yield was unusually low and contrasting periods in which the Treasury yield was abnormally high.

The missing connection between interest rates and stock valuations is not just a U.S. phenomenon. Japanese interest rates plunged over the past 30 years, but their long slide did nothing to make Japanese stocks more valuable in the eyes of investors. As rates declined, so did valuations. “Interest rates have been at zero since 2016 and P/E ratios are anything but extreme,” Mr. Rabener writes.

The biggest reason why there is no clear relationship between interest rates and stock valuations is because interest rates can mean different things at different times.

Interest rates may be flying higher because inflation is increasing and investors are demanding a better payoff to offset the risk that creeping price pressures will bite into their real returns. On the other hand, interest rates may be surging because real economic growth is booming and investors are asking for a higher return on their savings.

The message for investors depends on what the main driver of higher rates happens to be.

If stronger economic growth is the major force pushing rates higher, the implication for stock valuations is overwhelmingly positive, according to Aswath Damodaran, a professor of finance at New York University, who explored the interest rate connection in a recent blog post. Higher growth rates in the real economy usually offset the effect of investors demanding higher rates of return on their money.

In contrast, rising inflation is nearly always bad news for stocks. It suggests macroeconomic risks are rising. It also threatens profit margins at companies that can’t easily raise their prices to compensate for increasing price pressures.

So which factor is predominant right now? The initial comment by Ms. Yellen, a former chair of the Federal Reserve, seemed to hint at worries that inflation is on the verge of breaking out.

She later clarified her thoughts, saying she was neither predicting nor recommending a rate increase. Any surge in inflation as economies reopen in the months ahead is likely to be transitory, she said.

This may be somewhat disingenuous. Market-based estimates of expected inflation have shot up in recent weeks. Many people are bracing for inflation to run higher over the next decade than it has over the past decade.

But is that really a major concern? The market is indicating it expects U.S. inflation to hover around 2.5 per cent a year over the next 10 years.

That would be higher than in recent years, but only half-a-percentage point above the 2 per cent level that many central banks target. Certainly not reason for panic.

What is clearer is that economic growth will be red hot this year. Growth will hit 6 per cent in Canada this year and 6.5 per cent in the U.S., according to Capital Economics. That is twice as fast as anything we have seen in recent years.

To be sure, much of that growth is simply a bounce back from a disastrous 2020. But it is still good news. If interest rates are rising because of a fast-mending economy, investors should take heart, not run for the exit.

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