Will Rising Interest Rates Be the Convenient Excuse for a Market Correction?

 | May 16, 2018 | 7:55 AM EDT
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For many years one of the key bearish arguments has been that the unwinding of the massive central bank stimulus would cause interest rates to rise and the stock market to fall.

The logic of the argument seems compelling. The market has been riding a wave of cheap capital created by the Federal Reserve for a long time and when the central bank starts to unwind this massive debt, rates will have to increase.

The bulls' response is that the economy is now much stronger and can handle higher interest rates. Earnings are solid and valuations are still quite reasonable even if we have to use a higher discount rate due to inflationary pressures.

The problem with this argument is that the stock market doesn't listen to economists. It is an emotional beast and if the idea takes hold that higher rates, a hawkish Fed and inflationary pressures are a problem then we have little choice but to take notice and react. While 3% interest rates are still historically low the issue here is market perception rather than the actual economic impact.

The stock market and the economy are only loosely correlated. Just because the economy is doing well doesn't mean that stocks will follow and vice versa. We don't need to fall into a recession for the market to correct.

What really matters is whether the market is looking for an excuse to correct. There are periods when no negative news can impact the market. We have seen times when endless negative headlines cannot stop an uptrend but there are other instances when the market is looking for a reason to correct and rising interest rates are a very convenient excuse.

The indices were overbought the last few days and that made the selloff on rising 10-year Treasury yields very convenient. In addition, we have some drama out of North Korea as a nuclear deal no longer seems quite as simple.

My big concern about the market right now is that market players are struggling to find positive catalysts. They have shrugged off the trade war issue for the most part and have felt good about international relations in general, but earnings season produced a poor response and negative seasonality may be an issue for the first time in years.

It is easy to find reasons to not worry too much about higher interest rates but what really matters is whether the market will use them as an excuse to correct. Whether it is justified or not isn't the issue. If the market is inclined to correct then rates are likely to be the excuse that is given.

There is a flat open on the way and not much news flow other than North Korea. Bonds are flat but the dollar is up again.

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