Why Are Interest Rates Rising?
The Federal Reserve AKA “The Fed”, which is America’s Central Bank, is in the beginning innings of a rate hike cycle intended to curb spending, which would reduce inflationary pressure.
What is an interest rate?
You’re listening to the nightly news when the anchor chimes in with some boring information:
“The Federal Reserve is considering a rate hike.”
“Ok?” you think to yourself “So, what?!”
Interest rates to most people are not, well, interesting. But that doesn’t mean we should ignore them. They determine things like how much you will pay for a loan and where you will get the best return on your investments, so it’s helpful to understand how they work.
When you borrow money from a bank or a person, you will be charged a fee. This fee is the interest. When this fee is low, you will feel more comfortable spending the borrowed money since it’s relatively easy to repay. Similarly, when the rate of interest is high, you will spend less since it will be harder to repay.
Scale this up to the national level and you can begin to understand how the government controls the economy. When the Federal Reserve (the people responsible for setting interest rates) needs to curtail the country’s spending they will raise interest rates. If they want to motivate us to spend, they will lower rates.
The graph below outlines the negatively correlated relationship between the Federal Funds Rate and equity prices. Almost always, as rates rise, stock prices decline.
As you can see, when rates are high, there’s not much spending activity. No one is borrowing money to buy things or start businesses and few people are investing in the stock market. But when you look at the right side of the graph, where interest rates are low, we see a surge in economic activity. Depending on what is happening at the moment, interest rates can be raised or lowered to encourage or discourage economic expansion.
Why is this important?
By paying attention to interest rates, investors can make wise decisions regarding borrowing, investing, saving, and spending.
Let’s look at a few examples.
Borrowing: American homeowners are familiar with interest rates because of the correlation to their mortgage.
When you apply for a mortgage, a good indicator of whether it may or may not be an optimal time to finance a home is the interest rate. If rates are high, it’s better to wait. But if they’re low, as they have been recently over the past few years, buyers get a deal that amounts to a LOT of savings over the life of the loan. Generally, consumers take out more loans (auto, home, etc.) during periods when interest rates are low.
Investing: Let’s say you want to invest $100,000 in the stock market. Someone tells you that it’s a good time to invest in companies that build homes and you want to do some research.
A good place to start would be interest rates. Why? Because, like we just talked about, when interest rates are low, people are able to get a desirable rate on their home loan. Thus, homeownership is likely to go up in this “low rate environment.” So you could conclude that yes, it is a good time to invest in home-building stocks. Conversely, if interest rates are high, few people are going to buy homes, so you could conclude that home-building companies are probably not the best investment.
Saving and Spending: If your bank is offering you 5% interest on the money in your savings account, you’re likely to keep cash in that account where there’s no risk. If they’re only offering 1%, however, you’re wise to consider seeking higher returns by investing in the stock market. Your personal decision to save a small amount of money in your savings account may seem trivial but when you realize everyone in the country is likely doing the same thing, you can understand the huge implications this has on the economy.
High Interest Rates = Saving = Economic Decline
Low Interest Rates = Spending = Economic Growth
Why now?
In March 2020, when Covid began to pose a serious threat to the US economy, the Federal Reserve made the decision to lower interest rates. This is standard procedure when the government wants to stimulate the economy. (For context, rates have been declining for the last 40 years, and in this particular move the Fed set a target rate near zero percent.)
Following this action, multiple economic relief programs were authorized, flooding the economy with trillions of dollars of cash. This, coupled with an inability to go outdoors and spend money in their communities, made Americans flush with cash.
When interest rates are near zero, the American consumer has no incentive to keep their money in savings because of the paltry return. What do they do in this situation? They spend (and/or borrow) at record rates. Companies’ valuations rise both due to consumer spending and because their share prices increase as a flurry of new investors begin to participate in the stock market.
Consumption reaches extraordinary levels and we’re not able to produce the number of goods and services that are in demand. Prices for the limited supply of goods and services go up, and we’re left with inflation.
As we know, inflation is not a good thing. The Federal Reserve is responsible for combatting inflation, and to do so they will eventually need to again pull their levers to modify America’s monetary policy.
So What?
Yesterday, the Fed announced the second rate hike of the year—75 basis points—bringing the current target rate to 1.5% - 1.75%.
Knowing this, and the Fed’s plans to continue increasing interest rates, we can adjust our investment positioning accordingly.
During the height of the pandemic, many assets were trading at significant premiums relative to their earnings. Some of these assets (meme stocks) were artificially run up because of the “cheap capital” that retail investors had access to. Being overvalued, these companies are positioned to suffer in a rising rate environment because people will exit these positions to move to safer (more fundamentally sound) investments.
In the same vein, there are businesses that have not seen exponential growth during the pandemic that are valued reasonably. Disciplined investors have no intention of exiting these positions. These companies may not have been caught up in the meme frenzy or featured on sites like Reddit, but they will continue to provide value to the world and grow healthily even in a rising rate environment. It’s our job to identify those businesses and invest in them.
This is where a strong case for active investing can be made. You can generate strong returns through “picking the winners” but it’s equally important to make sure you’re not invested in the losers. Entering a rising rate environment, it’s important to understand there will be a flight of capital out of the markets and it won’t be from the high-quality companies that have strong earning potential - it will be from the over-inflated assets that are due for a correction.
In this scenario, it becomes clear that there is value in downside protection and that meaningful alpha can be generated by preventing losses even if your best stocks may not be rising in price.
For a more thorough explanation of interest rates and how investors can position themselves for a change in America’s monetary policy….
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