How to Spot Market Tops: Interest Rates

Market Peaks can be identified.

In previous articles, we discussed ways to spot stock market peaks. Here, we will show how interest rate increases by central banks usually precede market crashes. More specifically, we look at the relationship between the “federal funds rate”, which is set by the US central bank, and the S&P 500.

Typically, the central bank raises the funds rate when it believes economic activity is picking up and inflation is rising. Therefore, the start of an interest raising cycle is a positive sign for the stock market, as it implies that the economy has started to improve.

However, it is when the interest raising cycle goes on for a prolonged period of time that investors should begin to worry, as that signals the economy may be about to peak. In fact, historically, we see a negative relationship between the federal funds rate and the stock market.

S&P 500 vs Federal Funds RateSource: Gurrib 2015, “The impact of the federal funds rate on an investor’s return”, Journal of Economic & Financial Studies, 03(01), 74-82

The following chart by Putnam Investments shows the relationship between interest rates (in orange), recessions (in grey) and the stock market (green if rising, red if declining).

This chart gives us two key insights. First, we notice how almost every recession started after a period of increasing interest rates. Second, we see that almost every bull market ended after a series of interest rate increases by the Fed.

Federal Funds Rate (orange) vs % Change in S&P 500 (green if in a bull market, red if in a bear market)Shaded areas indicate recessions. Source: Putnam Investments

There are exceptions, of course, and not every cycle is exactly the same. However, a prolonged period of interest rate increases is a useful indicator for spotting market tops.

Recently, the Fed started raising interest rates, which may indicate that the current bull market still has some room to move higher. And as we can see from the chart below, interest rates are still at relatively low levels.

Source: Federal Reserve Bank of St. Louis

But should GDP growth start to strengthen materially, leading to a significant ratcheting up of interest rates, we would begin to consider the possibility of a significant down turn ahead.