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How Interest Rates and the Stock Market Are Intricately Intertwined

 “The most important item over time in valuation is obviously interest rates.”

Warren Buffett

Quite a statement and my thought is, how much do we understand interest rates and their effect on the stock market? In the chaos of the stock market today, with the extreme volatility we have been experiencing between the coronavirus concerns, ongoing oil war, and the abnormally low interest rates, there are a ton of worries right now as an investor.

Recently, the Fed lowered the interest rates by 50 basis points in the hopes that this might stop the bleeding in the stock market. It didn’t seem to make much difference, and there are rumors that the Fed will lower the rates a full percentage point, bringing the rates to lowest since December 2008 at 0.25%.

These rates are and would be the lowest in US history, and are historically low in the world. These rates have a significant impact on the stock market, as well as the bond market, mortgages, credit cards, and all credit devices.

In today’s post, we are going to discuss:

  • What Interest Rates Are
  • Fed Funds Rates
  • Interest Rates and the Bond Market
  • Why Do Interest Rates Change
  • How Interest Rates Affect the Stock Market
  • What Kinds of Companies Far Well in Rising/Falling Rates?

What Are Interest Rates?

According to the balance:

An interest rate is the percentage of principal charged by the lender for the use of its money. The principal is the amount of money loaned.”

Anyone can borrow or lend money, but banks are the principal borrowers and lenders. Banks use our deposits from our accounts, either checking or savings to fund loans. They pay us an interest rate for the use of our funds and to encourage us to deposit our funds in their accounts.

One of the most critical ways that banks make money is the spread on the interest rate they charge you to borrow money from them, as opposed to the interest rate they give us for our deposits. Most people think it is on the fees they charge us, while annoying is not anywhere near the truth.

The rates a bank will charge us for a car loan depends on either the 10-year Treasury Note or the Fed Funds Rate. More on that in a moment.

Where interest rates can get tricky for borrowers is, when you pay only the interest rates on loans, you are not attacking the principal, and if you don’t pay the interest rate in your payment, the total amount of the debt will grow.

Fed Fund Rates

This from Investopedia:

The federal funds rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.”

All banks and other depository institutions have a mandate that they have non-interest bearing accounts with the Federal Reserve to ensure they have enough funds to cover any depositors’ withdrawals. Each bank must keep in its accounts a balance that is known as a reserve requirement, which they base on the bank’s total deposits.

The good news for the banks, if they have reserve excess, they can lend that to other banks with interest. The interest rate that these banks lend at is referred to as the fed funds rate.

The board of governors of the Federal Reserve Banks meet eight times a year to discuss rates and set the target rates for banks to use. The governors do not have the power to dictate to banks what specific rate they charge; instead, they set a target rate such 1% to 1.5%.

The banks negotiate the rates between the two banks.

While the Fed can’t dictate the Fed Funds Rate, they can manipulate the rates by adjusting the money supply. If they increase the amount of money in the system, they can adjust rates down, and likewise, with a decrease of money in the system, increase rates upward.

The fed fund rates are by far, the most important rate in the US economy because it affects both the monetary and financial conditions. Including items such as employment, growth, and inflation or deflation. Also influenced by the fed funds rate are short-term rates such as home loans, car loans, credit cards, and mortgage rates.

The stock market also keenly watches the fed fund rates because the market reacts very strongly to changes in the rates.

Correlation of the Bond Market

Interest rates and bonds have an inverse relationship, think of a teeter-totter. When the interest rates rise, the prices of bonds fall, and when interest rates fall, bond prices rise.

The correlation may seem strange, but let’s dive in a little closer and try to reason this out.

An easy way to think of it, most bonds pay a fixed interest rate or coupon. If the interest rates fall, the coupon of the bond becomes much more attractive, and investors will bid the price of the bond higher.

Similarly, if the interest rates rise, the coupon rate becomes less attractive, and investors will bid the price of the bond lower.

Like all investors, bond investors are looking for the best return. If interest rates rise, giving the bonds an yield of 8%, then the old bond yielding 5% becomes less attractive, or not at all. Who wants to own the lower-yielding bond? No one!

To attract the investor to the lower-yielding bond, they would have to lower the price of the lower-yielding bond to make it more attractive and reach the same yield as the higher-yielding bond.

Let’s take a case study to help illustrate how this works.

  • You buy Microsoft’s AAA-rated bond for $1000
  • It matures in 10-years, and we get our original $1000 back. Yippee
  • The bond has a 3% coupon which means we get 3% a year, or $30.

Now, one year later, the interest rates increase to 4%, and you decide “I need to sell my bond”.

When you enter your order to sell, other potential investors are going to compare your 3% yielding bond to the current 4% bonds on the market.

To match the yield on the 4% bond, you will need to adjust your price to match that yield.

Let’s say the 4% bond matures in three years; we will need to adjust our price.

If the investor buys our 3% bond and holds it to maturity, they will yield $270 over the nine years in interest payments. The math equals $30 x 9 or $270.

Now the math on the 4% bond would be $40 x 10 and would equal $400 over the ten years.

To make up the difference in the yield, we would have to lower the price of our bond to $925 to achieve the same 4% yield.

Now because the investor was able to buy the 3% bond at a lower price, they would be able to achieve the same total return if they held the bond to maturity in ten years. You would receive the full $1000 if you held the bond to maturity in ten years, regardless of which price you pay for the bond.

The reverse of all the above happens if rates fall. Bonds that are farther from their maturity date will be more susceptible to interest rates, and fluctuations in price are more likely.

Another idea of the correlation between stocks and bonds, when the stock market takes a downturn, people sell their stocks and put their money in the bond market for safer returns.

Overall, bonds are much more tied to the interest rates and fluctuations of the rates the fed issues, where the stock market is related more closely to the performance of the companies in the stock market.

Bonds that feature high-yield or junk status are much closer linked to the market because the underlying businesses that issue the bonds are volatile. The volatility causes the prices of the bonds to fluctuate similar to a stock.

Why Do Interest Rates Change?

In relation to the Federal Reserve, more money in the system lowers the interest rates. And, conversely, less money in the system raises the interest rate.

The Fed uses interest rates to control the flow of money in the system. Using the system of supply and demand to set rates for borrowing, either from the fed funds rate, fed rates for banks to borrow from them, or the rates consumers are charged to borrow money.

The Fed will set rates based on the economy, inflation, unemployment, and supply and demand.

The money supply in the US economy will fluctuate based on the actions of the Fed and commercial banks. According to the law of supply and demand, the interest rate charged will be higher or lower depending on the amount of money in the system.

If there is an increase in the amount of money available borrowers, this will increase the supply of credit. Likewise, the credit available to the economy decreases when lenders decide to delay payments on their loans. When we choose to delay paying off our loans, we cause a decrease in the amount of credit available in the market, which in turn increases the interest rates in the economy.  

In addition to supply and demand, market risk is another factor regarding interest rates. Risk premiums reflect the amount of risk an investor is willing to take on an investment.

The risk premium guides the investor’s willingness to take an investment, for example, say an investor likes an investment for 5% and another for 6%. But the 6% investment is riskier, to take the investment, the investor might require a higher risk premium to take that risk, say 8%. The rising risk premium also causes the interest rates to climb according to the riskiness of the stock market.

Inflation is also a factor involved in interest rates. The higher inflation goes, the higher interest rates rise. The rise in rates coincides with the demand for more money to compensate for the decrease in buying power in the current economy. Lowering the interest rates helps keep inflation in check, allowing our dollars to go farther, in theory.

How Interest Rates Affect the Stock Market

Any changes in the interest rates can have a positive or negative effect on the stock market. When the Fed adjusts the rates that banks borrow money, it has a cascading impact across the economy and the stock market.

As credit contracts spending dips, and as credit expands, spending extends. The ebbs and flows of credit have an impact on businesses, as people have more money to spend that will send more money to the bottom line, bolstering the market. As for spending contracts, that means less money to the bottom line, which drives down stock prices.

All of the ups and downs of spending has an overall impact on the economy and stock market.

We investors have multiple options to invest our money, such as stocks with fantastic dividend yields, certificates of deposit, or a US T-bond. Our job as investors is to choose the option that provides us with the best rate of return, at a risk profile, we can stomach.

The fed funds rate will have a tremendous impact on our choice, as the fed fund rate affect the rate of both T-bonds and CDs. Mortgage rates are closely tied to the 10-year T-bill, and those rates are aligned with the fed fund rate.

The rising or falling interest rates will affect the psyche of both businesses and consumers. As rates climb, spending will slow or cut according to the rising rates. The cuts in spending will cause earnings to drop and stock prices to fall. Conversely, if rates fall, then spending will increase as businesses and consumers believe their more strength to the economy; this, in turn, causes stock prices to rise.

Valuing stock prices when interest rates rise or fall can have an impact on the discount rate we use to assess companies. Typically, when interest rates rise, the discount rate will increase as well.

Because stocks derive their value from discounting future cash flows to the present value, the higher discount rate reduces the value of those cash flows. The decrease in the present value will cause the stock price to decline because the present value of the cash flow is lower.

Think models like a discounted cash flow or dividend discount model which use guesstimates of rates for both present value and growth rates.

Another valuation method, using multiples such as the PE ratio, states that a rise in interest rates will cause decreases in multiples, which also causes the stock price to decline.

Types of stocks to buy when interest rates fall

There are different sectors or types of companies that fare better when interest rates are falling. I will list some of these types and why they fare better. Please don’t consider these stock recommendations, and please do your own research before investing.

  • Utilities – are defensive in nature and tend to fare well in falling interest rate environments.
  • Health Care – health care stocks have a long track record of performing well during falling interest rate environments. When interest rates are cut, it usually signals a weakness in the economy, and health care stocks typically have consistent revenues and higher dividends. Companies such as Johnson & Johnson (JNJ), UnitedHealth Group (UNH), and Prizer (PFE) are businesses worth consideration.
  • Consumer Staples – This sector tends to do well when rates are falling. Think of companies like Walmart (WMT), Target (TGT), Costco (COST), and Home Depot (HD).
  • Mid-Cap Stocks
  • Commodities – think companies like Exxon Mobil, except that Exxon is being hammered in the oil war with Russia.
  • Dividend Aristocrats – companies that have been paying a growing dividend for over 25 years do well in interest rate declines. Think AT&T (T), Walmart (WMT), Target (TGT), and 3M (MMM).
  • Pharmaceuticals – think Abbvie (ABBV), Amgen (AMGN), and Walgreens (WBA)

Types of stocks to buy when interest rates rise

Now, let’s explore some companies that might produce well during rising interest rate environments. Again, please do your research before buying any company.

  • Banks – financials, as a rule, do very well when interest rates rise, as they derive quite a bit of their income from net-interest income from loans. Think of companies like JP Morgan (JPM), US Bank (USB), Bank of America (BAC), and Truist (TST).
  • Dividend-Paying Stocks – see above in regards to Dividend Aristocrats
  • Stocks with Low-Multiples – low-multiple stocks have higher earnings yields and a more substantial risk premium. The higher risk premium gives low-multiple companies a great cushion to resist higher rates. Look for companies trading at multiples below industry standards. Use ratios such as PE ratio, PB ratio, or PS ratio. Different sectors are going to be undervalued at different times, depending on where you are in the market cycle, an example of financials being unloved currently.

Final Thoughts

Interest rates have a significant impact on the stock market and are extremely misunderstand by the general public.

The Fed uses interest rates to try to control the amount of money in the economy and uses rates to control credit usage. The theory that has grown since the last financial crisis of 2007 to 2009 is that the Fed can use interest rates as a bullet to help stop a stock market crash.

That theory is certainly taking a hit in today’s market, as it has been hit by the health crisis of Coronavirus and the oil war between Saudi Arabia and Russia. Stocks have plummeted to levels not seen in over 10 years, and the interest rates are currently at 0%, which is the lowest in US history.

Time will tell if the Fed has the strength to help rescue the market and if they have any other weapons to use to try to stabilize things currently.

For more on the Fed and their monetary policy, I strongly recommend that you read Ray Dalio’s Big Debt Crisis; it is dense but enlightening. It has helped me understand the situation we are currently going through.

As always, thank you for taking the time to read this post. I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time.

Take care,

Dave