“It’s all About Interest Rates…”
I remember the first day in my introductory Finance course in business school. The Professor, Dr. Melicher, made a sweeping opening statement. He said something along the lines of “Finance is the study of the effect of interest rates.” Well, being the cocky 20-year-old that I was, I did an internal eye roll. This Professor (who, by the way, chaired the university’s Finance department and authored the Finance text we used in class and was widely used in many universities) clearly did not know what he was talking about. I knew darn well that Finance was about the stock market…and real estate, and bonds, and all kinds of fun stuff that had nothing to do with interest rates, which to me, were the rates paid at the local bank or on a car loan or student loan.
Needless to say, Dr. Melicher (now Professor Emeritus) was oh so right, and I was oh so wrong, but it took years after his statement for me to realize his meaning and fully comprehend it. In fact, I eventually made a multi-decade career specializing in the impact of interest rates on banks and their investments. Thank you, Dr. Melicher!
Why are interest rates so important? As Warren Buffett expresses it, interest rates are the gravity of the financial system. When rates are low (now) asset prices tend to levitate easily. When rates are higher, gravity tends to exert a downward force on the value of all financial assets.
More mathematically, interest rates are the denominator of most financial valuation equations, whether for appraising a small business or valuing a bond, or pricing a piece of commercial real estate, or valuing a stock. In fact, changes in the denominator often dominate changes in the numerator (the cash flow produced by the investment), because a small change in the denominator can have a large and opposite effect on the result of the equation. This is not just some academic theory. This is how assets are valued every day throughout the financial system.
Why does this matter now?
The Federal Reserve has indicated that they plan to raise interest rates in order to combat inflation and ease off of the stimulation of the economy and financial markets. This is good news for savers and investors since we will be able to earn higher rates on relatively safe investments.
However, the problem is that every single recession (there have been ten of them) in the last 75 years has been immediately preceded by the Federal Reserve raising interest rates. Every single one:
In the graph above, the shaded vertical bands are recessions. The blue line is the short-term interest rate set by the Federal Reserve. As you can see, every single recession is preceded by an interest rate increase (and followed by a rate decrease).
Still, recessions are a normal part of the business cycle, so why should we care?
Every recession in the past 75 years has in turn been accompanied by a stock market decline of from 22% to 56% and averaging 37%. Again, every single one:
We are long-term investors, so why do we even care about market declines, which are just part of investing?
As long-term investors, one of the few things we can control is the entry price. Entry price ultimately dictates any investment's return. And while not attempting to time a downturn, we want to make sure to have "dry powder" in reserve so that we can buy when the opportunity presents itself, whenever that time comes. The danger in a down market is not so much the immediate loss itself, because that generally reverses in a few months or years. The unfortunate aspect is not being able to buy when the buying is good and really good investments can be found. So for that reason, I'm preferring to keep deployable assets on hand to be used when the time is right. That mutes returns for now, but it also reduces exposure to a pricy and bubbly market that is potentially vulnerable to interest rate increases.
Could this time be different?
So interest rates are likely to go up, and that has historically and understandably been bad for the financial markets. But there are at least three important differences this time.
First, interest rates are SO low right now that they will still be fairly low, even after substantial increases. Even after raising rates around 2%, as the Federal Reserve is projecting, those rates will still not be especially restrictive. Some might even still call them stimulative. Even if executed as projected (a big "if"), they would rise to a level that would still be below the starting point in most previous cycles. That part is different this time.
Second, for rates to have an impact on the stock market, rates have to rise enough to present attractive alternatives to stocks. That is the practical enforcement mechanism by which the academic formulas operate in practice. Right now, TINA ("There Is No Alternative" ...to stocks) is the catchphrase. Rates are so low that it doesn't make sense to buy long-term bonds or even CDs at the bank. It is possible that a 2% rate increase, if that is what we get, still will not present an attractive alternative, and money may stay put in the stock market this time.
Third, this time, there is still over $2 trillion in unused stimulus money and newly created money supply sitting in bank accounts nationwide. That idle cash could continue to come into the stock market (and other financial markets) and drive prices higher, even in the face of rising interest rates.
These are things to consider. But also, it is often said that the most dangerous words in finance are "this time is different." It usually isn't.
What does this mean?
Having spent most of my life in Colorado and Montana, I’ve learned to drive more cautiously on slick roads, and that is my analogy for the investment markets right now. No need to stop the trip or turn around or make any large adjustments at all. (Definitely don’t slam on the brakes!) We will just drive more slowly and ensure a safe arrival at our destination. That’s my thinking as we enter the potentially slick roads of a rising interest rate environment.