Investors often hear that interest rates and stocks move in opposite directions or that rising interest rates are bad for stocks. Generally, this appears true, but the relationship has proven to be more complicated. To understand interest rate movements and stock prices, investors should understand:
- 1) why the Federal Reserve changes rates;
- 2) what impact rate changes have on the economy;
- 3) how stock prices are affected by interest rates;
- 4) how expectations play a role in the stock market.
Why does the Federal Reserve change interest rates?
The Federal Reserve is charged with several mandates, and among these is to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Federal Reserve uses several tools to accomplish this; among these is the federal funds rate.
The federal funds rate is the interest rate at which commercial banks lend overnight funds to other commercial banks. At the close of business, banks are required to hold a ratio of collateral relative to the amount of deposits they have. A bank calculates how much collateral it should have and if, at the end of the day, it is short, the bank is required to borrow overnight funds from another bank. Alternatively, if a bank has excess funds available, it can lend money overnight to other banks. If a bank is unable to borrow overnight, it can go to the Federal Reserve but doing so too often raises an audit or worse. Thus, banks prefer to borrow from one another only as needed. Today the effective federal funds rate is 0.83%.
The federal funds rate impacts the interest rate banks charge their customers and how much a bank pays on savings accounts. This rate also impacts car loans, credit cards, mortgages, and all other types of lending activities. In turn, this directly impacts the economy. Lowering the rate lowers the rate banks lend money, which makes corporations more willing to start new projects and increase hiring. Similarly, as rates decline, consumers are more likely to buy a home or car as the rates decline. This increase in spending has the effect of speeding up the economy.
The St. Louis Federal Reserve Chart 1 depicts the federal fund rates since 1955. The gray areas are recessions. The federal funds rates increased and decreased based on decisions made by the Federal Reserve board of governors. The federal funds rates were lower at the end of a recession when compared to the start of the recession. Similarly, as the economy recovered and the recession moved to a more distant past, the federal funds rates typically increased. This has the effect of slowing the economy.
CHART 1: FEDERAL FUNDS RATE
The reason the Federal Reserve changes the interest rate is because it is attempting to manage the speed of the economy and employment. Essentially the Federal Reserve wants to prevent boom-bust periods while providing stable growth. To achieve this, the Federal Reserve must keep inflation in check.
A weighted basket of goods measures inflation called the consumer price index (CPI). Over the last few decades, CPI has typically averaged around 3%, but in 2022, CPI exceeded 8%.
This is because of the extraordinary measures that had to be taken during the 2020 pandemic.
M2 is a measure of cash in the economy plus bank deposits below $100,000. The St. Louis Federal Reserve graph depicts the annual growth rate of M2 over the last sixty years. Today, the economy has a substantial amount of money in circulation chasing a limited number of goods. The below chart (chart 2: M2) graphs the amount of money available in the economy. During the pandemic, this increase was beyond extradentary.
CHART 2: M2
When comparing inflation against M2 (chart 3: M2 AND CPI), the picture becomes clear that M2 directly impacts inflation. To control inflation, the Federal Reserve can’t increase the amount of goods, but it can reduce the amount of available money. The Federal Reserve changes the amount of available money by changing the federal funds rate. To increase supply, it lowers the rate, and to decrease supply, it raises the rate.
CHART 3: M2 and CPI
How do rate changes affect the economy?
The increase in interest rates can seem counterintuitive when wanting to slow the economy. The problem with inflation is businesses project their investments and expansions based on long-term expectations. Higher inflation creates greater uncertainty in forecasting, making managers less willing to risk the firm’s capital on projects, reducing future employment. Left unattended, the economy might eventually slow inflation, but the peaks and valleys of the recessions and boom periods would be longer and more exaggerated.
RULE OF 72:
Take any interest rate and divide it by 72 to determine the number of years for that value to double. For example, if inflation is 8%, divide 72 by 8, and that is how long (9 years) it would take for a $1 candy bar to cost $2. Similarly, if I invest $1 at 8%, that $1 would become $2 in 9 years. At 3% inflation, that candy bar takes 24 years to double (72/3 = 24).
Increasing the rates might seem to increase the inflation, but instead, it slows down consumption which in turn continues to slow down the demand for goods. The decline in demand results in businesses increasing prices at a lower rate. Thus, inflation comes under control in time. But the increase in the federal funds rate takes months to work its way through the economy; the change is not instantaneous.
Currently, however, inflation is being driven by a composite of unique factors and not just M2. These include the supply chain crisis, which is due to a combination of structural issues with shipping ports and COVID, to commodity prices spiking due to the Russian invasion of Ukraine. Thus, this time, things are a bit more complicated for the Federal Reserve and this uncertainty has increased the volatility in the stock market.
One measure of stock market volatility is the Chicago Board of Option Exchange’s Volatility Index (CBOE VIX or VIX). This measures the overall volatility expectations of the S&P 500 for the next 30 days. As VOL climbs, the market swings increase. Chart 4 depicts the VIX over the last several decades. The 2020 COVID pandemic put the volatility near the highs seen during the Great Financial Crisis (2007 – 2009). However, with the pandemic more in the rear-view mirror, the current issues of inflation, and the root causes of inflation, have driven up the VIX. In part, this has to do with the math behind calculating the value of stocks.
CHART 4: VIX
Stock Valuation Models
Stocks can be valued under numerous methods, from liquidation to revenue and earnings expectations. Different types of companies and industries use different forms of valuations. For instance, a company that is capital intensive will use EBITDA, or earnings before interest taxes and depreciation. A technology company might use revenue because it has no earnings. But ultimately what drives the value of a company’s stock is the idea that the majority owner(s) can control the earnings the company derives.
This is to say that if you owned 100% of a company’s stock, you could decide to pay yourself all of the company’s earnings or, if you desired, reinvest the earnings back into the company. Or a composite of the two. For companies that are considered ongoing concerns, there are three primary methods used to value stocks: discounted dividend model (DDM); discounted cash flow (DCF); and the capital asset pricing model (CAPM).
The DDM and DCF models base the calculations on the present value of the money. The first step in these valuations is to compute the expected value received each period. An analyst does this by forecasting earnings 3 to 5 years forward and then creates a terminal value for the periods beyond the 3 to 5 years. Terminal value is the amount received in the final years, adjusted for expected long-term growth. Here three different rates are used, but they are tied together. The first is the company’s earnings growth rate, second is the terminal rate of earnings growth into perpetuity, and third is the average cost of capital to the firm (WACC). The WACC is essentially a weighted average of the firm’s cost to issue debt and equity and involves the current interest rates along with the firm’s credit profile.
The reason the terminal rate and discounted cash flow rates are important has to do with the time value of money. In essence, $1 received 5 years from today does not buy the same value that $1 buys today. At 2%, the value of $1 doubles in 36 years, but at 10% interest, that value doubles in 7.2 years (rule of 72). Thus, these rates can substantially impact the value to be received.
Below is the formula for the two Stage DDM (left) and the DCF Model (right). D is the dividend at various times (1, 2, 3, N), r is the WACC or rate, and G is the expected growth rate of future dividends. The DCF model runs essentially the same way, but it uses cashflows instead of Dividends (D).
DDM and DCF MODELS
The other model, CAPM, derives the expected return of the investment by adding the risk-free rate (typically the 3-month treasury) to the expected value of the stock’s riskiness relative to the market (beta) and excess return above the market.
In all three valuation cases, the interest rate directly impacts the computation of the final value. And, as the rate used to discount the value increases, the expected value received increasingly declines.
The inflation rate is a key ingredient in the expected rates used in the models to derive valuations. The risk-free rate is tied to the 3-month treasury bill, which increases in yield when the Federal Reserve increases the federal funds rate. The interest rate at which a firm borrows also climbs as the Federal Reserve increases its federal funds rate. Similarly, under the DDM and DCF models, the rate used to discount funds back to today are dependent upon the rate the firm can borrow or issue equity.
When the Federal Reserve increases the discount rate, professional investors realize that several issues are occurring. First, the math behind the calculations will deflate the value of the investment. The Federal Reserve typically does several rate hikes in succession to allow each hike time to work through the economy, essentially to not shock the economy and provide time to measure the potential impact. Thus an increase of 25 basis points is not significant by itself, but an increase of 200 basis points can be very significant when coming off near 0% rates. Second, the economy will slow, which requires a review of expectations in revenues and cost structures for each firm.
This is the second shoe to drop.
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Stock Valuation and Expectations
Assume a firm forecasts current-year revenues of $100m and expenses of $85m, which involve mostly plant and equipment. For simplicity, taxes are 10% and there is no debt or other expenses and 13.5 million shares are outstanding. Further, assume the stock trades at 15x price to earnings multiple. This puts the stock at $15 per share. Now let’s assume the Federal Reserve needs to raise rates.
If we make broad assumptions, we know that the economy will tighten, and revenues will decline. Assuming a small decline of 2.5% in total revenues, the new revenue estimate declines to $97.5m. Because the firm’s cost structure is mostly plant and equipment, there is only a 2.5% reduction in expenses. After taxes, the income declines to $13.16m from $13.5m. This results in earnings per share of $0.98 compared to the $1 expected under the first scenario.
Additionally, because rates are moving higher, investors tend to sell out of stocks and raise capital which places downward pressure on the P/E multiple. We assume the new multiple trades at 13x instead of the 15x in the first scenario. As a result, the stock price drops to $12.68 from $15—approximately a 15% decline in stock price.
The change in interest rates also works in the opposite direction. If rates are expected to decline, expected revenues increase, investors pile into stocks, and price multiples such as P/E expand. The net effect could be the reverse of what happened here.
Interest rate expectations and stock prices
Stock prices make assumptions about the future, such as expected earnings, future sales and developments, and the direction of interest rates and inflation. As the economy begins to heat up, the market often anticipates that the Federal Reserve will increase rates. Similarly, companies begin to reduce expected sales expectations and begin to curtail future projects and hiring. This is called the Expectation Theory.
The Federal Reserve often telegraphs its views of the economy to the market. This allows the market to adjust to potential rate changes before they occur and, ideally, avoid significant market swings. Thus, stocks are likely to decline as inflation begins to indicate it is a problem even before the Federal Reserve raises rates. Conversely, stocks typically appreciate when the Federal Reserve signals rate hikes are done, even when economic news might appear less favorable to outsiders.
When looking at interest rates and stock prices, there is a lot to consider: price multiples, changes in revenue and expenses, discount values, and expectations of where the Federal Reserve is at in the rate change cycle. The change in rates directly impacts a wide variety of items that, when combined, can significantly impact the near-term stock valuations and increase volatility. However, as expectations become more mainstream and rate changes are telegraphed and implemented, the volatility of the market subsides, and it, the market, establishes a new base upon which to grow again.