Stock Markets: Short Term Interest Rates

This type of chart is intended to predict share prices based on government policies, using data on monetary policy available at the time. Short-term interest rates are used for the Local and Dollar Investor’s Perspectives. Real effective exchange rates, as calculated by us, are used for the Global Investor’s Perspective. (See Investor Education > Conceptual Framework > Proprietary Indices for further explanation) Best Guesses as to the effect on markets are shown as red arrows embedded in the price index.
 
In each chart the stock market index is shown as the thick white line on the right hand axis. The main explanatory variable, interest rates or real effective exchange rates, uses the left hand axis, shown as the thin yellow line. The left-had axis is inverted to compensate for interest rates and share prices moving in opposite directions traditionally, if not in recent years. For comparability stock market indices have been rebased to set year-end 1994 at 100.
 
The selection of monetary variable depends on the user’s choice of Investor’s Perspective. Interest rates are useful in predicting share prices in absolute terms, either from the Perspective of a Local Currency or Dollar Investor, but tend to have an opposite effect on the exchange rate, so limiting their usefulness for global comparisons. Therefore for the Global Investor’s Perspective only, real effective exchange rates are used instead. The series is expressed as a rate of change indicator.
 
This strategy works on the assumption that governments rarely make a change in policy all at once, but spread out over a number of intermediate steps, so the effects of a change create a trend over time that investors can exploit. However, in times of crisis this is not the case.
 
Buy signals for Local Currency and Dollar Investors are generated when interest rates begin to fall. Sell signals arise when the converse applies. Buy signals for Global Investors are generated when the real effective exchange rate accelerates and sell signals when it decelerates. Noise reduction methods have been employed to minimise the number of signals.
 
Traditionally share prices moved inversely to interest rates and inflation, but in the past decade the opposite has tended to occur, now that low inflation appears to be increasingly well established around the world.