Ultimately, this stock market rally lives and dies on interest rates

09/30/2009 5:54 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

So it's a good thing when people such as Federal Reserve Vice Chairman Donald Kohn say that the Fed will keep interest rates near zero “for an extended period” as he did in a September 30 speech in Washington.

As long as interest rates are so low, bond yields on the 5-year Treasury note of 2.3% and on the 10-year note of 3.3% don't provide much competition to stocks. Those low yields push investors to consider buying stocks since they're the only game in town offering a decent return.

Sure stocks are riskier than bonds but with traditional blue chips like Pepsico (PEP) paying a dividend yield of 3.1%, Verizon (VZ) paying 6.3%, and Chevron (CVX) paying 3.8%, you've got to admit that stocks look relatively appealing.

So every time a Federal Reserve official speaks about jacking up interest rates fast and hard, as Fed governor Kevin Warsh did on September 25, investors shudder. Warsh said that rates may need to be increased “with greater force than is customary.”

And every time an official like Kohn or the Federal Reserve's Open Market Committee itself says that rates are staying low for a long while, investors breathe a sigh of relief. That relief may not translate immediately into a move up in stock prices but it does put a general floor under stock values.

One caveat in all this talk of interest rates. Rates right now are so low because the Federal Reserve is trying to rescue the economy from a recession by making credit cheap. The rally in stocks that began on March 9, 2009 is based on a belief that interest rates are going to stay low but that the economy is recovering.

If interest rates go up before anyone expected that could sink stocks. If the recovery is further off than anyone now expects that too will sink stocks--no matter where interest rates are.

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