Today, I’d thought I’d explain what’s often taken for granted.
In fact, in yesterday’s Money Morning it was me glossing over this very subject: interest rates.
Try not to fall asleep just yet. Before this article is over, I’ll show you the secret power of interest and how it controls asset prices all over the world.
But first, let’s take a look at what I wrote yesterday:
‘Thank goodness we’re in a low interest rate environment. For those of you holding cash, it means you’re not losing your shirt.
‘If interest rates were higher, asset prices would be running away — a terrible situation for Aussies holding cash in the bank.’
Upon re-reading I can see how this could be confusing. Don’t stocks and other asset prices rise when interest rates fall, and the opposite when they rise?
Short answer: Yes, but it’s not a perfect inverse relationship.
So then why did I say that higher interest rates would cause asset prices to run away?
Let me explain.
The bluntest tool in the shed
It might not be the most interesting subject in the world. But interest rates are one of the most important variables for any investment.
To you or me, interest rates (not the cash rate) are the fees to borrow money. It’s also the return for saving it.
You know you can earn about 3% saving your money. So, any investment you make needs to at least exceed 3% to make it worthwhile.
To economists, interest is the tool to influence inflation. For example, when it’s running up (and assets collectively become more expensive), the Reserve Bank of Australia (RBA) might think about increasing the cash rate.
This is the rate at which banks lend to each other.
Following a higher cash rate is higher interest for you and me. If your mortgage is currently on a variable rate, then a higher cash rate will mean paying more interest versus principle each month.
However, when inflation is low (asset prices collectively aren’t growing), the RBA might think about lowering the cash rate. This will also likely cause commercial banks to lower their rate as well.
But how does this actually influence inflation?
Well, think of it like this. If interest is high, borrowing is expensive. People tend to borrow less. There’s less spending in the economy, reducing demand for goods.
When interest is low, however, then cash becomes cheap. The project or house that had a potential return of 6% now becomes a whole lot more attractive. And therefore, demand (and prices) for assets increase.
But this isn’t all the RBA does to pump up or lower inflation.
If they want higher inflation, they would lower the cash rate and buy Aussie bonds. To lower inflation, they would increase the cash rate and sell Aussie bonds.
The act of buying bonds essentially pumps more cash into the system. And by selling bonds, the RBA is sucking more cash out of the system.
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Alternatively, regulators could also lower the reserves commercial banks need to hold. This could also allow them to lend out more money, increasing spending and demand in the economy. But that’s a whole other story.
To sum it up, the RBA is just trying to influence how much cash banks like ANZ and NBA lend out to you and me.
If they can encourage banks to lend more, then inflation will probably increase. If they can encourage them to lend less, then inflation will likely decline.
Of course, theory doesn’t always work as well in practice. Which is probably why there aren’t too many millionaire economists walking around.
Many argue that influencing the cash rate (monetary policy) is a blunt tool. While the aim is to expand or contract an economy, it does not always have the desired effect.
All you have to do is look at Japan to see how ineffectual monetary policy can be.
From 2013 to present Japanese inflation has ranged from almost 4% to less than 0%. And throughout that time, interest rates were set at 0% and below. When interests rates are negative it means you pay interest to store your money in the bank.
Source: Trading Economics
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If we circle back to what I wrote yesterday, it’s assumed when interest rates are high, inflation is also high. Hence why I said that asset prices would climb.
But enough economics. Let’s look at how this affects individual investors like yourself.
What’s that stock worth?
How do you value a business (and therefore a stock)? How can you tell how much its worth?
Let’s say you own a business that has a five-year life. I’ll bet what interests you most is how much money you can take home.
Imagine paying $100 for a business. Assuming it produces a $25 profit annually, you’ve got yourself a 25% return each year.
If this is how we determine return, it’s not that hard to assume the value of a business (and therefore a stock) is the sum of all its future profits.
And because a dollar today is worth more than a dollar tomorrow, we also need to discount these future profits. You can thank inflation for that.
This is where interest rates come in.
They are an integral part when creating a discount rate.
As you saw earlier, interest is the return you can make while taking on no risk in a savings account.
So, if you can generate a risk free 3% you’ll probably want more when buying a business or stock, which may or may not pan out.
It’s why most investors like to add a premium on top of this risk-free return.
Maybe an additional 9% compensates for this risk? If that’s the case, your discount rate will be 12% (3+9).
Using our example from above, a business earning $25 for five years is worth approximately $105 today. I use the word approximately because in reality we cannot say for sure that a business (or stock) will produce $X annually.
Again if we circle back, increasing interest rates would then cause stock prices to fall. This is because when the risk-free rate is higher stocks become more expensive.
For example, say the risk free-rate increases to 6%. If you still want a 9% premium for taking on risk, that’s a discount rate of 15%.
Thus, if we discount $25 for five years at 15%, the business is now only worth about $99.
Of course, this doesn’t always happen. Just like Japan, many times stock movements will fly in the face of economic theory.
Take the most recent example in the US. The US Federal Reserve have pushed the Federal Funds rate up about 1.5% from 2016 to present. What have stocks done during that time? The S&P 500 (500 largest US stocks) is up more than 45%.
A likely explanation is because businesses earnings have risen much faster than interest rates. Again, you can thank inflation for that.
You can find other similar examples in the past. So while it’s a commonly accepted rule (the inverse relationship between stocks and interest rates), I suggest you not take it literally.
To summarise, what I failed to explain yesterday was the assumption of higher interest rates. If interest is high, it’s probably because inflation is high.
And in a world where inflation is high, those holding cash start to see their purchasing power decline.
Hopefully I’ve cleared that up while explaining a few points about how I like to think about interest rates.
Editor, Money Morning
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