Value investor with a deep passion for understanding and a desire to improve results over time.
If the Fed Raises Interest Rates, What Happens to Stocks?
You've spent all this time learning about value investing principles, when to buy and sell a stock, portfolio allocation, and great tools of fundamental analysis. You've read all of Buffet's letters to shareholders, picking up some great quotes along the way, and all you want to do is go on the hunt for bargains priced well below their intrinsic value, selling at a decent margin of safety.
And yet, when you look out into the investing landscape and listen to what pundits are saying about markets, they seem to be focused on one factor above all the others: what the Fed will do with interest rates. Why does it matter what the federal funds rate is, and why should we care as investors whether interest rates are zero or 5%?
What Rates Are We Talking About?
First, we need to consider what a bank really is. We're not talking about a piggy bank where you keep your cash stored; keeping your money secured is just a small part of their job. Banks create money out of thin air, as Ray Dalio often puts it, and then loan it out to individuals or institutions. As long as the bank has enough reserves to allow for people who want to withdraw their cash during a given time frame, this system works magnificently to create additional liquidity or dollars in the system.
Since not all banks have the same amount of cash at any given time, and some banks end up with lower reserves than they should have, one bank may need to borrow from another bank in order to provide the cash they need for a given day. The rate at which banks lend to one another is called the overnight lending rate, and Investopedia does a terrific job of explaining the overall concept.
Since the amount of cash that's available in the system is constantly in flux, banks will tend to charge more money when cash is scarce. After all, cash itself is subject to the forces of supply and demand. Nearly a century ago, John Maynard Keynes used his immense influence and intellect to explain that central banks themselves could turn this equation on its head by artificially setting the overnight rate lower or higher.
Today in the United States, the Federal Reserve is able to manipulate this supply/demand process by lowering or raising interest rates, depending on the outcome they want to see. Lower rates mean more investment in companies (stocks), but why?
Two Parts of Valuation
In order to understand why falling interest rates mean higher stock prices, we need to step back and take a look at how companies are valued. Recall from this short primer how there are two equally necessary pieces to any stock valuation, at least from a value-investing perspective:
- The amount of cash the business is going to produce over all time
- Discounted back to today's values
Recall Aesop's fable, where the listener concludes that a bird in the hand is worth two in the bush. In essence, money today is worth a great deal more than money tomorrow. Why? Well, for one thing, there's optionality: you get to decide whether to spend the cash right now or at some later time; you simply don't get a decision if you're given the money later, no matter how much it is.
Second, and maybe more importantly, there's the opportunity cost to consider. A good investor understands that every purchase they make is made instead of another purchase, so comparing all of your available options is crucial whenever investing. Another potential consideration is even more direct: inflation. Cash is worth less next year than it's worth this year, and the higher inflation is, the more that is true.
The Discount Rate
That brings us to where the rubber hits the road, where individual investing and macro worlds collide. When you're doing a valuation and adding up all of the future cash flows, you need to discount each future year to what the cash is worth today. The discount rate you use can be deeply personal, based on your own opportunity cost. If you have some fantastic lower-risk opportunities to invest your cash, you'll need to consider adjusting your rate to match a much higher-risk venture. Since the flows will be less of a sure thing (birds in the bush), they're worth less.
If you examined your field of opportunities out there and you were able to find an opportunity that was completely without risk—virtually guaranteed to return your money to you with interest after a certain time frame—then you'd want to compare every single opportunity to this one, adjusting for the extra risk by demanding an extra reward (upside).
This so-called risk-free rate is often correlated with Treasury bonds since the interest payments on bonds are backed by the promise of the United States federal government, and defaulting is widely perceived as incredibly unlikely. So, if the Fed raises rates from 0% to 5% over a given time frame, it is very likely that Treasury yields will end up rising around 5% too. If Treasuries went from 0% to 5%, you'd need to demand something much greater than a 5% return; otherwise, why not just take the sure thing?
Rick and Returns
Looking at a specific example, if I have $100 to invest, and T-bills (short-term bonds) are returning 5%, and I'm looking at another potential investment opportunity, I'd insist on at least a 10% return and probably a lot more than that. Taking on additional risk demands additional potential upside, the reward in the risk-reward ratio. This amount is called the risk premium, and the risk premium that Mr. Market assigns tends to fluctuate over time. Treasury rates are very closely correlated to the overnight lending rate, so understanding this ratio is crucial.
It follows, then, that if the risk-free rate is very low, the expected return for stocks should also be relatively low. If the Fed raises the rates at which banks borrow, making it harder (more expensive) for companies to borrow, these companies are going to have less incentive to invest in capital expenditures, the purchases that make a material long-term impact on improving the business. The more investments going into the business itself, the more the business will improve over time, and the more it will likely be worth down the road.
Financial advisors and professional investors know this hard-and-fast rule all too well and will typically be much more eager to invest in business when interest rates are low, and they're even more likely to want to buy stocks, even if their expected returns are somewhat low, as long as the return they expect is sufficiently higher than the risk-free rate.
Interest rates, Warren Buffett has famously said, are like gravity for the stock market. When rates rise, the stock market almost always declines, and when rates are lowered, it can often trigger a rapid rise in stock prices. Understanding this relationship can help arm you in your quest to invest, and even value investors need to consider the cost of money when plotting out future expectations. After all, future returns are exactly what we're paying for when we invest, and knowing the fundamental forces (like gravity) is absolutely necessary in order to plot out any sort of future cash flow projection. Think about rates when you're investing.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith