April 1, 2015
A Market Report by Michael Dym
A very strange – even counterintuitive – phenomenon has been apparent in the market for the past half year: whenever the Federal Reserve expresses optimism about the macro-economy, stocks begin to sell off.
The culprit is, everyone knows, interest rates. The lower the level of interest rates, the better it is for stocks, and vice-versa. For the past few years, a weak economy has forced the Fed to maintain historically low interest rates. The conversation seems now to have turned. A strengthening economy pushes the Fed toward raising rates in order to head off potential inflation. This regime change – from ultra low to higher rates – scares investors. Indeed, even talking about it makes them nervous.
Why? Why are lower interest rates better (and, conversely, higher rates worse) for stocks?
1. Lower interest rates make stocks a more attractive investment.
When interest rates are low, fixed income investments do not provide enough of a return. Investors are forced to either keep their money in a very low yield instrument, such as a bank CD, or take on more risk by buying stocks. So, the low interest rate environment creates more demand for stocks.
This reasoning only really works for securities that would replace fixed income- preferred shares, REITs etc. It doesn’t explain the rise we see across almost all asset classes. It also raises two problems:
A) Why would news of a low interest rate extension further raise prices, if investors have already switched to stocks, and are simply delaying their exit? The announcement should simply stop prices from falling. If you respond that this is because the further delay removes some of the time of higher rates that was already priced in, that leads directly to…
B) If everyone knows that the Fed will raise rates (indeed, they basically said so), and the only question is when, why should that affect stocks at all? The fact that these same investors will soon flee from equities and go back into fixed income means that stock prices will fall then. If so, how can they rise now – their eventual decline should be “priced in” to the market now!
There must be other factors at work. So, here are two more:
2. Lower rates make it cheaper for businesses to expand.
Lower interest rates means lower debt service cost, hence higher profits – pretty straightforward.
3. Lower rates spur consumer spending.
This is a little less direct but is really tied to no. 2. Cheap money spurs spending in the aggregate. Households and firms are more willing to spend borrowed money. The more money spent, the more the economy grows. This is the real goal of lowering interest rates in the first place.
The longer rates remain low, the longer factors 2 and 3 prevail, and affect businesses. This explains why equity prices are driven upwards when investors conclude that the Fed will wait further to make a move. Conversely, when the rate hike becomes imminent, the hoped-for delay that was priced in disappears , sending stock prices lower.
What does this mean for us at S.I.DYM Financial? As long term investors, we view the adverse effects of good economic reports as temporary price movements caused by the actions of investors with narrow investing horizons. Their bad news – a stronger economy – is our good news.
