Today, we discuss interest rates. Many equity and other investors may not pay too much direct attention to interest rates; but, ultimately, we encourage all investors to pay close attention to interest rates because interest rates literally impact valuations of all financial assets.
Most simplistically, let’s think about a share of company equity (a share of stock in that company). Each share-holder owns a share of that company. That’s why “stock” is synonymous with “equity” and “shares”. If the company has 1 billion shares outstanding is earns $1 billion, the EPS, or earnings per share, would be $1 per share. If investors’ collective required rate of return to own that stock is 10%, then those shareholders, who comprise “the market”, will pay about $10 per share. However, if for some reason, investors’ required rate of return own that stock goes to 12% (maybe because the economy is getting better and now there are better alternatives), the “the market” will only pay $8.33 for each share of that stock. On the other hand, if investors only need 8% expected rate of return to own that stock (maybe because the company’s earnings are particularly stable), then shareholders will be willing to pay $12.50 for each share of that stock.
Similarly, bond prices trade inversely with changes in interest rates. Bonds are tradeable debt instruments issued by companies or governments or other entities who have borrowed money. Those borrowers promise to pay a particular interest rate until they repay the debt. The amount of the debt is called principle. With many bonds the principle is typically paid back all at once at “maturity” (when the bond comes due). So, if a government promises to pay a 3% coupon every year plus 100 cents on the dollar at maturity, and, for some reason, investors decide they now need 4% expected rate of return on moneys lent to that borrower, the value of the bond will go down. How much it goes down is a function of how much time remains before the principle is expected to get paid back.
Even gold and oil investors have to pay attention to interest rates. If for no other reason, they can choose to invest in “risk free” assets such as in very short term debt obligations of very high quality governments that can issue currency to repay its debts. US Treasury bills (debt obligations maturing in less than 12 months) are considered by many to be examples of “risk free assets” because the US government can print more money to repay those debts, if ever necessary.
The risk that the US government will print more money than needed for the expanding economy is the risk of possible future inflation.
Inflation is the debasing of a country’s currency.
In olden-times, peasants knew to try to bend money in their teeth. If the money could be bent, they knew the coins had a minimum amount of gold or silver. If the coin could not be bent, the peasants knew somebody had added other metals to the coin. Monarchs might try to get away with such debasing to reduce the value of the money they had borrowed. Wars were often paid for in such ways.
The risk of inflation — and the commensurate reduction in value of government-issued (so-called fiat-) currencies — is one of the many reasons many people like to own physical gold.
In addition to the risk of future inflation, another ramification of low interest rates is that investors must seek more-and-more risky assets and investments in which to invest. This can lead to “bubbles” (as the US experienced in IT in the late 1990s and then in real estate in 2004-2006).
It is likely that many investors choosing to invest in digital currencies such as Bitcoin are doing so as a hedge against future inflation, such as in the above rationale explained for owning physical gold.
Thus, we hold, all investors should seriously consider the ramifications of changing interest rates on the prospect of future values.
With that, we point out the report issued this week from the New York branch of the US Federal Reserve. In that report (see link below), the authors write that under their assumptions the overnight interest rate charged by banks to each other, the Fed Funds rate, “gradually declines from its current level [2.0%-2.25%] to a low of 1.2% in the second quarter of 2021. Thereafter, it gradually rises to a longer-run level of 1.5 percent. t/he ten-year Treasury yield and thirty year fixed mortgage rate are assumed to rise to 2.5 percent and 4.2 percent, respectively, in the long run.”
These are important because the last time the Fed provided its leaders’ projections on June 19th, they thought the overnight rate would only get down to 2.4% in 2021 and would be at 2.5% over the long run. So, in the report issued this week, the NY Fed is saying 2021 rates will be half the projections provided by the Fed’s leaders just 2 1/2 months ago.
From what we can observe from the 30 day Fed Funds futures contracts and the implied forward 1 year rates one year from now, these 2021 rates are not surprising to the bond markets.
However, we have observed that markets sometimes don’t pay attention to each other.
We hope with this note to draw your attention to what the Fed and the bond market are telling you.
US Federal Reserve board members’ forward projections, from June 19 2019:
Report this week from the NY Fed:
Tim Shaler is Chief Economist of iTrust Capital. He is a published Real Estate economist, was a portfolio manager and asset allocation expert at his previous firms and is an adjunct professor at Webster University. His MBA (Finance) and MA in Russian Economic History are both from the University of Chicago.
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