Why Do Interest Rates Matter?
By Zeke Anders on February 22, 2024
“Interest rates are to asset prices like gravity is to the apple.” -Warren Buffett
We have talked about interest rates a lot over the past two years. We talked about the impact that rising interest rates have on bond prices here. But why does the whole economy seem to rely on interest rates? How is it that raising interest rates fights inflation? Why do interest rates affect the prices of equities? We will cover all of the above in this piece.
Warren Buffett, in the 2013 Berkshire Hathaway annual shareholder meeting, said “Interest rates are to asset prices […] like gravity is to the apple.” There are two primary reasons interest rates affect asset prices, discount rates and the cost of leverage. Leverage is more straightforward. If a business can borrow at a lower interest rate, it may be able to grow faster. If I had a lawn mowing business and all I had was a push mower, I might be able to cut two lawns a day. If I had a riding lawn mower, maybe I could cut four lawns in a day. It might take me a while to save up to buy that riding lawn mower. If I can borrow money for that mower, I can start cutting more lawns sooner. If interest rates are low enough, I can grow my business and still make a profit. If interest rates are really low, I may be able to grow my business really fast, buying more mowers and hiring others to use them. If interest rates are really high, I may not be able to buy any mowers and still make a profit. Additionally, if someone wanted to buy my business, they might offer more money for it if interest rates are low, assuming they are borrowing money to purchase the business. If interest rates are high, they may offer a lower price, or not buy the business at all. Low interest rates may also allow unproductive or highly speculative businesses to survive longer than they otherwise would with higher interest rates.
Discount rates are more abstract. Discount rates are the rate of return you’d like to have on your investments. We touched on this a bit in our post about the time value of money (here). If I would like a 10% rate of return, I’ll pay a lower price than someone who wants an 8% return. This subjective discount rate is often based on the risk-free rate, which is generally the rate of return on 3-month Treasury bills. Stock prices are more volatile than Treasury bills, so investors want a higher rate of return to compensate them for that volatility. When the yield on Treasury bills was essentially zero, investors didn’t require as high a rate of return on equities. Many people said “there is no alternative”, “TINA” for short, to owning equities to get some rate of return. As of today, February 12th, 2024, the yield on 3-month Treasury bills is 5.39% annualized. Thus, investors will want a return higher than 5.39% for holding volatile equities, which, all else equal, means they’ll pay a lower price than if rates were lower.
As an example, if we are evaluating a stock which pays a $2 dividend every year for 20 years, we can calculate the present value at different discount rates. The present value, or the current price we’d be willing to pay, is below.
Source: author’s own calculations
You can see that at a low discount rate, we’d be willing to pay much more for the same stock compared to using a higher discount rate. The stock offers the same dividend in every scenario, the only thing that changes is the discount rate.
You might ask, “Why not always keep your discount rate high?”. If your discount rate is higher than the market, you may never find anything to buy. And if the alternative is low-yielding Treasury bills, you may naturally adjust your expectations of future returns. There are other factors that affect stock prices, such as the growth rate of the company, currency exchange rates, and cultural trends, but interest rates clearly play a meaningful role in stock prices.
This same concept applies to the lump sum offer for a pension, and for valuing Social Security benefits, too[1][2]. With lower interest rates, the lump sum value of a pension is higher. As interest rates rise, the lump sum offer is generally reduced.
Another way interest rates affect the economy is through mortgages. Many people in the United States buy a home using a mortgage, rather than with cash. As a result, people buying a home often pay more attention to their potential monthly payment, rather than the price of the home itself. During the pandemic, demand for houses increased as people began working from home, wanted more space, and couldn’t enjoy the amenities of apartment life anyway. Interest rates also dropped, which made the monthly mortgage payments affordable even at higher prices. Since then, rates have increased dramatically, which means the median mortgage payments has increased.
Source: St. Louis Federal Reserve as of February 12th, 2024
As an example, if someone wanted to borrow $400,000 for a house for 30 years at 3%, the monthly mortgage payment would be $1,686. The same mortgage at 7% would have a monthly payment of $2,661. That is a 57% increase and could be the difference between affordable and unaffordable. To keep the same $1,686 payment, the individual could only borrow $253,418 at 7%. Demand for housing has remained strong despite the increase in interest rates mainly due to low supply. Housing prices in some markets have held up better than others as well. But ultimately, it is clear that interest rates have a significant impact on the housing market, as well as commercial real estate.
Lastly, even the cost of insurance is tied to interest rates. Life insurance companies take the premiums you pay for life insurance and annuities and invest them primarily in corporate bonds. If the yield on those bonds is higher, they can offer new life insurance policies at lower prices, increase payouts on new annuities, or increase profits. As interest rates rise the value of their existing portfolio will decline, because bond prices decline as yields rise[3]. New policies, however, may benefit from the higher yields.
For decades, interest rates gradually declined, and it was easy to forget how much they impact markets and the economy. The volatility in rates over the last three years has led to volatile markets, inflation, and even bank failures. This is why interest rates are followed so closely by investors and businesses. Hopefully this piece provided some insight into the ways interest rates affect all of us.
[1] https://www.reuters.com/business/retail-consumer/senior-kfc-executives-opt-retirement-interest-rates-hit-pension-payouts-wsj-2022-10-15/
[2] https://www.wsj.com/personal-finance/retirement/pension-lump-sum-monthly-payment-retirement-f94ad69b?mod=Searchresults_pos8&page=3
[3] https://twickenhamadvisors.com/blogs/unobstructed-thoughts/a-note-about-bonds
Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com
Disclaimer
Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.
