To what degree do stock markets love low interest rates?

First, let’s establish how low interest rates are in the U.S. and Canada. The federal funds rate of America’s central bank, the Federal Reserve, is officially in a range of 0.25% to 0.50%. U.S. 5-year and 10-year Treasury bills are 1.20% and 1.70% respectively. All of those yields, once the core inflation rate is taken into account, are negative. (Core inflation omits volatile energy and food components and is presently running at +2.3% year over year.)

Currently, AAA corporate bonds in the U.S. are offering 3.32%, according to Moody’s. State and local bonds are paying 2.85%. The prime rate charged by U.S. banks on corporate loans is 3.50%.   

In Canada, the central bank’s key policy-setting interest rate, the overnight rate, is 0.50%. The most financially sound business firms north of the border are facing a chartered bank prime rate of 2.70%.

Retail commercial bank customers in Canada are earning 1.38% on 5-year GIC’s (Guaranteed Investment Certificates). Canada’s core inflation rate, as of August 2016, is +1.8%

By way of comparison, how are the major stock market indices performing? In accompanying Graphs 1 through 3, exponential trend lines have been superimposed on the actual data points for the Dow Jones Industrial (DJI), Standard & Poor’s 500 (S&P 500) and NASDAQ indices since their latest trough levels in early 2009. The equations for the exponential curves are shown in the boxes.

The R² value, which can range from 0.00 to 1.00, indicates how good the fit is between the trend line and the actuals. An R² value above 0.80 but below 0.90 is okay-to-good; beyond 0.90, it is excellent-to-outstanding.

For all three indices in Graphs 1, 2 and 3, the R² values are higher than 0.90, indicating that the trend lines are in extremely close alignment with the actual historical index values.

The trend lines have been used to calculate annual compound growth rates. For the DJI, the year-to-year rate of increase since the Great Recession has been +11.0%. For the S&P 500, it has been +13.0%. And for NASDAQ, it has been an almost unbelievable +16.2%. High-tech has been where the action is in appreciating equities has been the hottest.

(For the Toronto Stock Exchange (TSX), the annual rate of increase has been +4.4%, but the R² value of the exponential trend line is a disappointingly mediocre 0.5763. The TSX has suffered from a weak resource sector that has been bruised and battered by depressed global commodity prices.)

The U.S. Federal Reserve has, for a long time, been promoting an inexpensive interest rate policy. Earlier in the cycle, the Fed also pursued quantitative easing (i.e., printing money) with a passion. The fear has always been that this would, possibly inordinately, drive up the value of certain assets, such as stocks, real estate and ‘collectibles’ (e.g., fine art, vintage cars, etc.).

Based on the extraordinary growth rates for the three major stock market indices shown in Graphs 1-3, versus the vastly more subdued returns from lending and borrowing instruments, there can be no doubt that some striking imbalances have indeed been introduced onto the U.S. financial scene.