Why Do Interest Rates Matter?Submitted by Canty Financial Management on May 1st, 2018
If you are invested in the stock market you may think interest rates have little to no effect on your portfolio. This is a very common misconception. Interest rates are among the most important measures in our financial system. Interest rates have a significant impact on our daily lives and it is vital for all investors to understand the influence interest rates have on their portfolio.
1. Price of money - What it costs for companies and individuals to attain capital
The most important concept to understand about interest rates is that an interest rate is the cost to attain capital. It is what you must pay to borrow money. For this reason, interest rates have a tremendous impact on the economy. Think about an economy where there are high interest rates and it is very expensive to borrow money. This will cause less people to take out loans and decrease overall spending in the economy which lowers growth. This is why an increase in interest rates is considered monetary tightening in the economy. It increases the cost of capital and decreases spending. In an economy where there are low interest rates money is cheap and more people will borrow thus increasing total spending and increasing economic growth, this is known as monetary easing. You may think so why don't we leave interest rates very low? Won't it be better for the economy? The answer is no. When money is too easy to attain it can cause issues such as inflation or overspending which can result in an overextended or overheated economy. This is one of the reasons why the Federal Reserve aims for a steady 2% inflation target.
2. Fundamental Valuation of a stock
It is also important to understand how interest rates impact other risky assets such as stocks. A stock price according to a fundamentalist is simply the sum of all future cash flows (per share) discounted to the present value. Without getting too technical, discounting must occur because a dollar today is worth more than a dollar tomorrow (due to inflation and time value of money). For this reason we must use a percentage to discount these cash flows that the stock is generating. Many equity pricing models use a function of an interest rate, such as the 10 year treasury, to generate a discount rate. The relationship shows that higher interest rates must increase the discount rate for a stock. A higher discount rate results in lower cash flows and a lower intrinsic dollar value for the stock. This discounting formula is the underlying framework of fundamental analysis. This is how traditional fundamental investors such as Warren Buffett value a company on paper.
3. Competition between bonds and stocks: Capital flow
In our financial system capital flows to where it is most necessary. This creates competition between asset classes. One of the most competitive is the flow of capital between stocks and bonds. People like to hold bonds because they are less risky, but have low returns. People like to hold stocks because they have a high returns, but carry more risk. So there is always this trade-off between risk and return. For this reason, as interest rates rise, more people are attracted to buy bonds because they offer higher returns. This often causes capital to flow out of equity markets and into bond markets. A perfect example is a value stock that pays a dividend of 3%. If interest rates on the 10 year treasury rise from 2% to 3% people are more likely to buy the treasury bond over the stock because there is less risk involved. As a result capital will flow from the stock to the bond everything else equal. Capital flow can have a significant impact on equity and bond market prices.