Interest Rates: How They can Help Us or Hurt Us

15 minutes

 

Today’s interest rates are currently the lowest in human history. There are some countries in the world that are offering negative interest rates which means that you have to pay your bank to keep your money in their accounts.

There has been a lot of talk in the news about interest rates and how they affect us. With the rates being so low and all the talk about how they are going to start raising them, I thought this would be a good time to discuss why this is big deal and how it affects our investments.

How did we get here, to begin with? Well in 2008 when everything went sideways in the markets, economy and real estate the Fed needed to do something to try to stop the bleeding. One of their actions was to lower the interest rates. They ended up lowering them to 0.25% which was the lowest in US history. Originally they had set the benchmark level to be a 1% but they felt that the only way to get ahold of this was to lower the rates to this unprecedented level.

The rates have remained at this level until recently they have begun to raise them slightly. Last year in December 2015 they raised the rates 25 basis points or 0.25% and this December 2016 they raised them another 25 basis points.

What is the Federal Reserve?

The Fed was established in 1913 and up to this time the US was a considerably more unstable place financially. Panics, seasonal cash crunches and a high rate of bank failures made the US economy a poor place for international and domestic investors to place their money.

It was J.P. Morgan who forced the government into acting on its decade’s long plans of creating a central bank. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge and into a full crash and depression.

Morgan was able to convene with all the principal players at his mansion and command that all their capital flood the system, thus floating the banks, that in turn helped float the businesses until the panic passed.

The fact that the government had to rely on a private banker for its economic survival forced it to pass the necessary legislation to create a central bank and the Federal Reserve.

The Federal Reserve was given control over the money supply and, by extension the economy. During the crash of 1929 and the start of the Great Depression the Fed stood by and did little to nothing to prevent or soften the blow that followed during those years. This has been hotly debated in the years following about what impact they could have had but the fact that they did nothing was definitely a factor in the length and depth of the Great Depression.

During the crash of 1987 Alan Greenspan gathered all the leaders together echoing J.P. Morgan and during his meeting, he dictated that the major players flood the markets to keep the banks afloat. He also instituted lowering the interest rates as a weapon to control the economy. This was the first time it was done and it set a precedent.

The Fed uses the control of the interest rates to make corporate credit easy to get, thus encouraging business to expand and create jobs. Unfortunately, this can also cause inflation to rise. To control this they lower interest rates which cause the economy to slow and can cause unemployment. So it is a double-edged sword.

How Interest Rates work

Definition of the federal interest rate. This is the interest rate banks charge each other to lend Federal Reserve funds overnight. These funds maintain the Federal Reserve requirement. This is what the nation’s central bank requires they keep on hand each night.

The reserve requirement prevents them from lending out every single dollar they get. It is designed to make sure they have enough cash on hand to start each business day.

The Federal Reserve uses the Fed funds rate as a tool to control the US economy. This makes it the most important interest rate in the world.

Banks use the Fed funds rate to base all other short-term interest rates. It includes LIBOR or the London Interbank Offering Rate. This is what banks charge each other one-month, three-month, six-month and one-year loans. It also includes the prime rate, which we will tackle in just a moment.

Banks charge their best customers the prime rate, and this is how Fed funds rate affects most other interest rates. These include interest rates on deposits, bank-loans, credit cards, and adjustable-rate mortgages.

Longer-term interest rates are indirectly affected. Typically, investors want higher rates for a longer-term Treasury note. To show how interconnected this all is, the yields on Treasury notes drive long-term conventional mortgage interest rates.

This makes sense because lately, the yields on Treasury notes have been going through the roof, basically since the election. This, in turn, has caused a rise in rates being offered by banks for mortgages. Amazing how this is all connected.

The current Fed funds rate is .75%. It was voted on by the Federal governors to have it raised this last December 14, 2016.

This is a year since its last raise in December 2015. Before that, it had been driven to zero by Ben Bernanke in 2008 to combat the financial crisis that swirling around the country at that time. It depends on who talk to whether that worked or not, it remains to be seen.

Interestingly, the highest rate so far was 20% in 1979. Paul Volcker used it as a tool to combat inflation at that time.

Banks hold reserve requirement either at the local Federal branch office or in their vaults. If a bank is short at the end of the day, it borrows from a bank with extra money. The Fed funds rate is what banks charge each other for overnight loans to meet these reserve requirements. The amount borrowed and lent is known as the Federal Funds.

The Federal Reserve’s Open Market Committee (FOMC) sets the target for the Fed funds rate. It can’t force the banks to use its targeted rate. Instead, it uses the open market to push the Fed funds rate to its target rate.

If the Fed wants to keep the rate lower, they will purchase securities from its member banks. It deposits credit onto the bank’s balance sheets, giving them more reserves than they need. This means the bank must lower the Fed funds rate to lend the extra funds to each other.

Conversely, when the Fed wants the rate higher, it does the opposite. It sells securities to other banks, removing funds from their balance sheets, which gives them fewer reserves.

The FOMC uses the Fed funds rate as a tool to help control inflation and maintain economic growth. The Fed governors watch economic indicators for signs of inflation or recession. The key indicator for inflation is the core inflation rate and the key indicator for recession are the durable goods report.

It can take 12 to 18 months for a rate increase to start affecting the US economy. Because they need to plan that far ahead they employ 450 people, of which over half are Ph.D. economists. Needless to say, they are the foremost experts on the US economy, or at least one would hope.

When the Fed raises rates, it’s called contractionary monetary policy. A higher Fed funds rate means banks are less able to borrow money to keep their reserves at the mandated level. This means there will be less money to lend out, and when it is lent out it will be a much higher rate. This is because the bank is borrowing money at a higher Fed funds rate to maintain their reserves. Since loans are harder to get, this means that businesses are less likely to borrow money as it will be at a higher rate and harder to get approved for.

When this happens it trickles down to other facets of the economy. For example, the adjustable-rate mortgages become more expensive, which means that homebuyers can only afford smaller loans which will slow down the housing industry. Housing prices go down, so homeowners have less equity and they feel poorer. This causes them to spend less money, which slows the economy.

Conversely, when the Fed lowers its rate. The opposite happens. Banks are more likely to borrow from each other to meet their reserve requirements when rates are low. Credit card rates drop, so people shop more. With cheaper bank lending, businesses expand. This is called expansionary monetary policy.

Adjustable-rate mortgages become cheaper, which allows people to get larger loans. This helps the housing market improve. Homeowners now feel richer and spend more. They can also take out equity loans easier. They usually use these loans for home improvements or other large purchases like vehicles. All of this stimulates the economy.

For all these reasons, stock market investors watch the FOMC meetings like a hawk. A drop of .25% of the rate will stimulate the economy which in turn causes the market to increase in the joy of the drop. If this rate stimulates too much growth, then inflation may creep in.

An increase of .25% in the Fed funds rate will curb inflation, but it could also slow growth and cause a drop in the markets. Stock market analysts pore over every word uttered by any governor on Fed board, looking for any clue or indication of where the Fed will go with their rates.

So how does all this affect the stock market?

Let’s take a look and see.

How Interest Rates Affect the Stock Market

Interest is essentially nothing more than the cost someone pays someone else to borrow their money. We have talked about how the Fed controls the fund’s rate and how that can affect the economy. Rising rates have slowing effects and possibly rising inflation and falling rates have a stimulating effect on the economy and lower inflation levels.

Basically, when the Fed raises its rates it is attempting to control the amount of money in the system by making it harder to obtain.

When the rates are raised it does not have an immediate effect on the stock market. Instead, the rise in rate has a single direct effect – it becomes more expensive for banks to borrow money from the Fed. Increases in the Fed funds rate has a ripple effect which affects both individuals and businesses.

The first indirect effect is on an increase in rates is that the money that banks lend to individuals becomes more expensive. Individuals are affected by increases in credit card and mortgage rates, particularly if they are variable interest rates. This causes the individuals to have less money to spend. I mean, we all still have bills to pay and if the larger costs in our lives increase, it means that we will have less discretionary money to spend. So less disposable income for items that are not necessary or we become much more choosy in what we decide to spend the money on.

This has an affect on the businesses that are dependent on those discretionary purchases. This affects both their revenues and profit, in other words, the bottom line.

Thus, the businesses are indirectly affected by the increase in Fed funds rate. But the businesses are affected in a more direct way. When the Fed funds rate increases it makes it more difficult to borrow money from the banks and their interest rates go up as well which drives up the costs of lending for the business. This, in turn, slows down the growth of the business which means fewer profits. It all goes in a cycle.

Now obviously the rise in rates affects both the individual and business but it also affects the stock market as well. Remember that one method of valuing a company is to take the sum of all expected future cash flows from the company discounted back to the present. To arrive at a stock’s price, take the sum of the future discounted cash flow and divide it by the number of shares available. This price fluctuates as a result of the different expectations that people have about the company at different times. Because of those differences, they are willing to buy or sell shares at different prices.

If a company is seen cutting back on it growth spending or is making less profit – either through higher debt expenses or fewer revenues from the consumer – then the estimated amount of future cash flows will drop. All else being equal – this will lower the price of company’s stock. If enough companies experience this drop in stock prices, the whole market or indexes like the Dow or S&P 500 will start to drop.

Of course, a declining market or stock price is less than desirable. All investors want to see increases in their stock prices. These gains are seen from the appreciation of the stock price or dividends, or both. With the lowered expectations of growth or future cash flows, you will start to see a decline in the market, which can make stocks seem less desirable.

When investing in stocks starts to be seen as too risky, then this gives rise to other less risky investments. With the rise in rates, you start to see an increase in government securities, Treasury bills, and bonds which will seem like the less risky investment. This occurs when there is a rise in the Fed funds rate.

This is referred to as the risk-free rate of return, and these go up the rush to investments such as T-bills and bonds will increase. When people invest in stocks they need to be compensated for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for taking this risk is the sum of the risk-free rate and the risk premium.

Naturally, everybody has a different level of risk they are willing to take a chance on. As the risk increases so do the risk premium, which some investors will be willing to take in order to get a better return.

In general, as the risk-free rate goes up, the total return required for investing in stocks increases. Likewise as the required risk premium decreases, while the potential return remains the same or goes down, investors might feel that investing in stocks is too risky and put their money elsewhere.

We’ve spent some talking about stocks, so let’s switch it up and talk a little bit about bonds and interest rates.

Bonds issued by the Treasury to fund the operation of the US government are referred to as US Treasury bonds, depending on the time until maturity, they are called bills, notes or bonds. Investors consider US Treasury bonds to be free of default risk. In other words, they believe the US government is unlikely to default on the interest payments and bond premiums of the bonds it issues.

So typically the risk-free rate we were discussing earlier will be based on the interest rates of these Treasury bonds. The most common used is the 10 year Treasury bond as a risk-free rate. Currently, as of December 24, 2016, that rate is 2.53%.

To understand how interest rates affect a bond’s price, we must understand the concept of yield. For our purposes here we will discuss the yield-to-maturity calculation. A bond’s YTM is simply the discount rate that can be used to make the present value of all of a bond’s cash flows equal to its price. In English, a bond’s price is the sum of the present value of each cash flow where the present value of each cash is calculated using the same discount factor. This discount rate is the yield.

When a bond’s yield rises, it’s price falls, and when a bond’s yield falls, it’s price increases. As you can see the interest rates are tied to the pricing of bonds. Right now there has been great volatility in the bond market because of the rise in Fed funds rate and the continued promise of more rate hikes in the coming year. As yields rise, the price or par value of the bond will drop.

Why to a discussion about bonds? Well, with the lowering of interest rates in 2008 there was a rush to bonds as the prices for those bonds increased as the yields dropped. Investors were looking for a safe place to park their money because as the year went on the stock market plunged over 50% and people took huge losses. And bonds are looked at as a safer bet than stocks, in other words, there is less risk involved. Now with the rise in Fed funds rates the yield is going to increase but the prices of bonds will sink like a stone which will lead to an exodus from the bond market and they will look for alternatives to invest in.

The silly thing that is going on right now is that people are looking at the stock market as a safer place to invest their money right now. With the market at all-time highs, seemingly everyday people seem to have lost their fear and thrown caution to win. There is, of course, the fear of not wanting to miss out going on as well.

They have forgotten what happened just a few short years ago. I am not saying you should abandon investing in equities but you should remain diligent in your choices and be cautious at all times. Mr. Market is always looking for an opportunity to take advantage when he can.

A word of caution about interest rates rising

In a word beware. With the rise in rates and the promise of more rate increases as we get farther into 2017, there will be a potential for a problem to start arising.

What is this problem? It is the use of borrowing or leveraging to buy back shares or payout dividends. As we have discussed as the rates rise the money that you have been borrowing to grow your business starts to become more expensive. That payment that you were making now starts to become a little more expensive than it once was.

How is this dangerous? Companies have been using this lower rate money to fund growth in their businesses. Whether it has been to help acquire additional assets or to reinvest in their company to drive earnings growth. There has been an expectation set that you must be growing your business and giving back to your shareholder, that has given you their hard-earned money.

To do this some companies have been borrowing money to cover these dividend payouts or share buybacks. There has been a rise in share buybacks in the market in the last few years. When this is done right it can be a powerful builder of shareholder value.

What are share buybacks you ask?

Stock buybacks are the repurchasing of shares of stock of the company that has issued them. Since shares are issued as a means of generating equity for the company issuing them, it may seem counter-intuitive to reacquire them. There are several reasons why a company would do this.

The first reason would be to take advantage of undervaluation. If a circumstance comes along that drives down the price of the shares perhaps due to some bad news. The company may take advantage of this news to repurchase its own shares at a much lower price. If the company is still profitable its price will bounce back and give the company an opportunity to generate more equity at a plus for themselves by reselling those shares that they had just repurchased.

Another reason for shares buybacks would be that it is an easy way to make the company look good to investors. By reducing the number of common shares that are available this would automatically make the earnings per share look much more attractive. In addition, some short-term investors may look to make a quick buck by investing in a company right before a scheduled buyback. This rapid influx of investors artificially inflates the stock’s valuation and boosts the company’s price to earnings ratio.

The reason why this leveraging or borrowing money to buy back shares can be so dangerous to the investors. If a company is borrowing to artificially inflate its earnings to appear stronger than they really are. This can lead to someone investing in a company that is not really as strong as they appear. This is why doing your due diligence when considering investing in a company is so important.

A few big name companies that have been using this system of share buy backs to appear more profitable and stronger than they really are.

The companies that I was able to find are McDonald’s, Lowes, ADP, Brown-Foreman. These companies currently have a high price to earnings ratios and have taken on more debt to reduce their share counts. And with the rising Fed funds rates that are going to be coming this can be a really dangerous action for these companies to take.

If you are a long-term investor this can be especially harmful to you. As the taking on of more debt simply to artificially elevate the financials to make it look better and not using the debt to increase the profitability of the company can be very harmful and one would argue, very short sighted.

This should be a red flag to long-term investors.

Final Thoughts

Interest rates have a huge influence on our economy and likewise on our markets as well. We discussed where the rates come from and how they are influenced.

I thought looking at the interest rate that is bounced around on the news media was worth a look. It was interesting to me how the Federal government uses rates to influence their monetary policy and how the banks use it to influence their lending rates and how much money they can lend out.

Given the recent discussions about the Fed funds rates being raised, I wanted to help us all understand how this can influence us when we are looking at investing in the stock market.

It is interesting to see how the Fed has used up its bullets with the recent downturn in the economy in 2008-9. With the rates at or near zero, they haven’t had much opportunity to influence monetary policy, with the economy stabilizing they have been able to raise the rates twice in a year. Keep in mind this is not a huge amount but they are promising more raises in the coming year.

The one aspect that doesn’t get talked about enough is the impact it can have on companies that have used leverage to either grow their business or to pay out dividends to keep shareholders happy. With the uptick in rates, it could cause some problems for these companies.

It is critical that you look into the debt that a company carries and how that debt was created and what it was used for. There are good kinds of debt but always do your due diligence to investigate further where the money went. This could save you a ton of money and a lot of heartache in the future.

I have to say this was a lot of fun for me to look into. I learned a ton and some things I can use for myself.

I hope that you found this of benefit and if you think it would help someone else please share it with them.

As always, thank you for taking the time to read this.

Take care,

Dave

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