Understanding the impact of interest rates
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Interest rates are the cost of borrowing money from a lender, and businesses and individuals borrow money for a range of reasons, so lending plays a significant role in the global economy. There is some ambiguity around interest rates, so hopefully, the following can bring some clarity.
Treasury Yields
Treasury yields are the stated interest rates that the United States government will pay to borrow money where the borrowing is backed by the full faith and credit of the U.S. government. Treasuries are as close to risk-free as an investment can get, so they serve as a baseline and any yield greater than treasury yields has an added risk premium. They are the most influential interest rate as they affect both businesses and individuals when borrowing money for purchases of long-term assets like real estate and borrowing for businesses. Treasury rates are also used as baseline inputs for valuations of assets like stocks and bonds, meaning changes in treasury yields also change the relative values of other assets. Treasuries influence the sentiment of the U.S. economy: rising rates suggest a positive economic outlook, and as we are experiencing now, it can also reflect a changing inflationary environment.
In order of shortest duration, the U.S. government issues Treasury bills (within one year), Treasury notes (2-10 years), and Treasury bonds (20-30 years).
A vital graph used to predict changes in economic output and potential interest rate changes is the yield curve. The line on the graph shows the spread between the 10-year and 2-year treasury yields. When the graph below is above 0, the 10-year rate is higher than the 2-year rate. A flat or humped yield curve has treasuries earning similar rates and can indicate economic uncertainty. Likely the most frightening yield curve for multiple reasons is an inverted yield curve, when 2-year yields are higher than 10-year yields. This happens when investors are less confident about the future and don’t want to lock up their money for a long amount of time. The fear stems from the historical correlation between inverted yield curves and recessions as seen below.
Federal Funds Rate
The federal funds rate is a target interest rate (a range of rates) set by the Federal Open Market Committee (FOMC) that serves as the rate at which commercial banks borrow and lend excess reserves to one another overnight. The FOMC sets the range in response to economic conditions to achieve economic growth. As consumers experience the change in interest rates, their spending behavior will typically reflect the change which will impact business and force companies to adapt, all of which affect the economy.
The fed funds rate influences short-term rates and impacts economic factors like growth and inflation. A consumer can notice these changes with higher or lower interest rates on their credit cards and similarly with mortgage payments- both of which are core categories to the consumer. Comparably, businesses can get access to cheaper or more expensive debt, which can accelerate or decelerate growth in the company. A favorable change in the fed funds rate grants businesses accesses to cheap capital, enabling them to fund growth opportunities. This leads to job creation, so individuals earn money to support spending, which essentially stimulates the economy.
Prime Rate
Also influenced by the federal funds rate is the prime lending rate- the rate that banks charge their most creditworthy borrowers. This rate serves as the starting point for interest rates charged to consumers. This typically affects consumer-oriented loans like personal loans, car loans, mortgages, etc.
Discount Rate
The discount rate is the rate the Fed charges commercial banks for short-term loans borrowed from the Federal Reserve. The rate is set by the board of the Fed. This borrowing is rare and typically for emergencies as it is used when a bank cannot find a lender in the open market.
Recent interest rate activity
Throughout the past two years, due to quantitative easing and money creation, the money supply has exceeded the supply of goods and services. Consumer balance sheets were strong, but due to lockdowns, travel restrictions, and supply chain constraints, there was a shortage of goods and services, resulting in lower spending and higher levels of cash balances. Throughout time, states, borders, businesses started reopening, which helped boost the economy.
With respect to financial markets, at the beginning of the pandemic, the Federal Reserve implemented quantitative easing by purchasing assets like treasuries and mortgage-backed securities as a form of quantitative easing to increase the supply of money to encourage borrowing and investing. It’s important to note that, at the time, interest rates were near zero, and naturally, there is an inverse relationship between the supply of money and interest rates. Quantitative easing has been credited to keeping markets afloat during the pandemic.
To summarize, inflation is the product of consumers having had too many dollars (savings and stimulus payments) chasing too few goods (restrictions and constraints) coupled with 7 billion notes being printed in the United States in one year, accounting for a substantial amount of all US dollars in circulation.
Fast-forwarding to around the end of 2021, the U.S. started experiencing higher levels of inflation, reporting the highest levels in the CPI measurement since the 1980s. To combat inflation, the Federal Reserve will adjust the federal funds rate to affect the supply of money.
In the case of high inflation, generally, the Federal Reserve will increase interest rates to slow down borrowing, which impacts businesses and individuals, which in turn can slow down the economy. Higher rates can slow down the economy with investing and spending slowing as expensive borrowing can be discouraging.
How do stocks perform in a high-interest rate environment?
Pre-pandemic and after the V-shape recovery, stock valuations were at historically high levels. A low-interest-rate environment can be attributed to high valuations but now, as we enter an environment with expected rate hikes, some stocks can experience downward pressure because of the nature of the interplay between interest rates and valuations. Growth stocks are sensitive to a rise in interest rates because companies must deliver higher growth to compensate the investor for allocating cash to the company rather than earning a rising risk-free rate. It's also important to note that when building a discounted cash flow model, a higher discount rate will lower generally lower the valuation of a given stock.
The context behind rising rates is likely more important than the direction of rates. For instance, if rates rise because of economic growth, this is good for businesses and can be a driving force to raise the price of stocks. What is important is the volatility of interest rates as investors are not comfortable with uncertainty. The importance of volatility is highlighted in the consequences of rate changes; if the Fed moves rates too much or too fast, it can cause a recession. Conversely, if the Fed takes too long, runaway inflation can occur.