Interest rates: what’s that got to do with it?
Interest rates: what’s that got to do with it?
Yeah, it's a good question — not only because it reminds me of a great old song, but also because it’s not obvious.
In the short term, in any given year, the stock market can seem all over the map. So a person’s time horizon, or the timeframe in which returns are expected, really matters. Treat investments as short-term bets and the potential outcome is likely just as varied. But with the benefit of a longer timeframe (say, five to 10 years, or even longer), investing starts to look less like a bet and more like, well, an investment — an investment in potential returns from capital expenditures, management decisions, and ultimately (and hopefully!) growth and profits. In this way, while returns are not ensured, it removes the short-term noise from the endeavor.
Chart sourced from an analysis of the range of one-year, five-year, and 10-year rolling returns, month by month, over this four-year period. For example, a 10-year return in November 2018 reflects the return from November 2008 to November 2018. The minimum and maximum one-year, five-year, and 10-year annualized return, of all the returns, is then shown. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.
After all, as a stock investor, you are a partial owner of a company. And as a partial owner, you are not only taking on all the costs and downside, but all of the potential upside, too. So what do interest rates, influenced by the Federal Reserve, but also by the demand and supply of US government debt (treasuries, for example) have to do with all that?
Well, to start, interest rates actually play a role in the value of nearly every investment that carries risk — stocks, bonds, real estate — and in different ways, commodities and options… the list goes on. The general reason is because, at its core, investing often represents participation in potential future cash flows and income. And, thus, valuing many investments means you have to translate the future income back to a value to you today. Three main things go into that translation:
A discount rate (where government interest rates form the foundation)
Expectations of earnings and growth
Sentiment on how sure it feels those cash flows would be received in the future
That’s a lot, so I’m going to focus on the discount rate part and cover the rest in a future post.
A discount rate, aka an interest rate, impacts valuations because it is a key input into the denominator of a general formula* used to value something (recall a denominator is on the bottom when dividing, vs. the top). Expected future earnings are not simply added up to form the current value of an investment like a stock. They are, instead, divided by an interest rate, which serves to reduce the value and puts future earnings in today’s value (aka present value). This is partially done because it helps take into account that cash alone earns a return – showing the value to you in today’s dollars, less a return from cash.
Given the discount rate goes in the bottom of the valuation formula, all else equal, the higher interest rates are in general, the lower the resulting calculated value is of any investment being analyzed.
As long as you understand this relationship, you can carry it through to many things, look at charts with a new lens, and apply this general rule in the future. For example, this is why we shared this chart last week, which shows S&P 500 valuations and 10-year treasury rates (and why they are, at times, mirror images).
The same general rule applies, for example, when analyzing the value of a bond. If interest rates fall, bond values generally rise and when interest rates rise, bond values generally fall. We could keep going here and say the same in real estate — when mortgage rates fall, home prices, for example, have been supported. When they rise, like now, you can start to see home prices at least stop rising.
So because of this relationship between interest rates and investment values, interest rates matter to investors. And relatedly, the Fed’s actions have an impact on interest rates, and thus, investment values. It’s why J. Powell’s “DJ sessions” — Fed meetings — have been a focus for us and many investors broadly.
*An example of a valuation formula is:
where, cost of capital is the discount rate or interest rate to assign to the investment
Source: Robinhood Financial, Bloomberg