Interest rates have fallen to historic lows recently. While this may be a boon for businesses looking to borrow or families refinancing homes, many retirement investors today are worrying about how rising future rates might affect their portfolios and whether they should move savings from low-yielding accounts to higher-yielding alternatives.

Let’s start with interest rates’ impact on stock prices. At the core of rising-interest-rate fears is the false notion that falling rates are always good for the economy (and thereby stocks), as they make borrowing cheaper, which spurs consumer spending and enables corporations to enjoy lower financing costs to fund new projects. And when rates rise, people and businesses have to pay more to borrow and may not spend as much or take on new projects -- potentially hurting the economy and stocks.

In reality, the stock market is a complex system and any single influence -- such as rising interest rates -- is unlikely to cause a consistently good or bad outcome every time.

Rising Rates Don’t Doom Stocks or the Economy -- Relative Rates Matter More

With today’s historically low interest rate environment, it may seem intuitive that rates can only go up from here, which could crimp borrowing and economic activity and be bad for stocks. While the Fed has signaled short-term rates are likely to stay low in the near term, long-term rates tend be driven by inflation expectations and could start to rise with accelerating economic activity.

However, as shown in the following exhibit, stocks have been consistently positive on average over 12-month time periods regardless of long-term interest rate movements. Whether long-term rates were rising, falling or staying put, stock returns have been positive 75% of the time and averaged greater-than-10% returns over 12-month periods historically.

Source: Global Financial Data, as of 02/07/2020. S&P 500 Total Return Index 12-month return and 10-year US Government Bond Index 12-month yields, monthly, 01/31/1926–12/13/2019.

Source: Global Financial Data, as of 02/07/2020. S&P 500 Total Return Index 12-month return and 10-year US Government Bond Index 12-month yields, monthly, 01/31/1926–12/13/2019.

That’s not to say interest rates don’t matter to stocks and the economy -- they do. But Fisher Investments believes the relative difference (spread) between long-term and short-term rates -- also known as the yield-curve spread -- is more meaningful for lending and economic activity than interest rate direction. The yield curve serves as a rough proxy for bank profitability -- banks borrow at short-term rates (think deposit accounts) and lend money at long-term rates, profiting off the difference.

A wide yield-curve spread incentivizes bank lending, driving credit and money-supply growth, which tends to boost economic activity. Conversely, narrow spreads may slow credit and money-supply growth. Importantly, many people fear negative spreads -- or an inverted yield curve -- which can choke lending and growth.

An inverted yield curve preceded the past seven U.S. recessions and, while not an immediate trigger for recession or a precise market-timing tool, many consider it a warning sign. With the Fed signaling it may not hike the fed funds rate (a proxy for short rates) anytime soon and inflation expectations (a primary driver of long rates) remaining tame for now, Fisher Investments doesn’t expect this warning sign to flash in the near future.

However, the U.S. yield-curve spread is currently narrow. Ten-year U.S. Treasury yields are at 0.79% -- historically low -- while the upper limit of the fed-funds target rate (representing short rates) sits at 0.25% -- also historically low.[i] This could mean tepid U.S. credit growth moving forward unless inflation expectations and long rates rise.

But this flattish yield-curve environment isn’t automatically bad for U.S. stocks. There have been periods, such as the years leading up to 2020, which featured a slim-to-slightly-inverted U.S. yield curve with generally positive stock returns.

Resist Chasing Yield With Your Emergency Fund

Though you may invest the bulk of your assets for the long term or for retirement, you probably also need to keep some money in safer investments or bank accounts to cover emergency costs. However, in a world with 10-year Treasury bonds yielding below 1% and bank accounts yielding near 0%, holding too much cash may not be prudent. Your rainy-day fund may earn next-to-no interest income and even lose purchasing power due to inflation.

This doesn’t mean you shouldn’t have an emergency fund, however. You can look into alternatives to traditional checking and savings accounts. You might consider vehicles like high-yield savings accounts, certificates of deposit (CDs) or money-market mutual funds to earn slightly more interest income. However, these alternatives come with their own risks and liquidity trade-offs, so you should do your research before making changes.

If you start looking at other liquid assets -- like bonds or even stocks -- you’ll likely have to accept more short-term volatility risk than might be desirable for a true emergency fund. Chasing yield or income with your emergency fund can be a dangerous game. If you fall on hard times or face unexpected expenses when stocks or bonds are down, you may have to sell those securities at a loss just when you need money most. While you may earn little-to-no return and lose some purchasing power on an all-cash or cash-like emergency fund in today’s environment, the goal for that money should never be about income or growth. For those, turn to a well-diversified portfolio that’s aligned with your goals and objectives.

Despite fears and chatter about today’s low interest rates, Fisher Investments doesn’t believe they are either inherently good or bad for stocks. In our view, what matters most for economic activity is the yield-curve spread.

Currently, the yield-curve spread is narrow, but positive. This should bode well for credit conditions moving forward. And while low interest rates may not bode well for your emergency fund or cash holdings, make sure you don’t get lost in the chase for yield. Doing so could be detrimental in tough times when you may need cash most.

[i] U.S. Treasury and Federal Reserve Board, as of 10/09/2020. Based on the daily 10-year Treasury yield and the Federal Open Market Committee’s (FOMC) target federal funds rate or range.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.