Why are investors obsessed with interest rates?
When I began my career with NBD Bancorp, my colleagues would gather around the Quotron machine every afternoon to get the reading on the CRB (Commodity Research Bureau) Index. After more than a decade of high inflation, investors were attuned to any sign that it might accelerate once again. The CRB Index covered 21 commodities, and it was viewed as a harbinger of inflation. But inflation wasn’t the real worry; no, the real fear was high interest rates to combat inflation.
37 years after my trip down memory lane, investors remain obsessed with interest rates. The question is, “Why?” Interest rates are crucial to stock investors for several reasons.
First, interest rates are a good barometer for the economy and have predictive value. When an economy has been growing strongly for several years, imbalances show up. Certain components and commodities may be hard to obtain as supply has failed to keep up with rising demand. When demand exceeds supply, Economics 101 says prices go up.
In response to rising inflation, the Federal Reserve raises interest rates to bring down inflation before it gets out of hand. This slows demand for capital investments and consumer purchases by raising the cost of financing them. However, rate hikes frequently go too far, sowing the seeds of the next recession. Consider how the abrupt increase in interest rates in early 2022 triggered a bear market in stock prices, fearing a recession that thankfully never came.
On the other hand, very low interest rates are frequently a sign that demand has been weak, producing low inflation. In periods of weak demand, producers are hungry for customers and hold the line on prices. These low interest rates plant the seeds for an economic recovery by making it easier to finance capital investments and consumer purchases.
The Federal Reserve tries to counter economic changes before they go too far, raising rates when the economy appears in danger of overheating and cutting them when conditions appear to be going slack. Changing interest rates are an early sign of upcoming changes in the economy, and that’s important to investors.
The stock market is a great discounting mechanism. Investors project business conditions several quarters into the future and adjust their portfolios well before the economic headlines change. That’s why stock prices turned around in March 2009 even though the economy was in terrible shape.
Second, most large companies borrow money. High interest rates increase their costs while low interest rates can reduce their costs. These impact corporate profits which are the ultimate driver of stock prices over the long term.
Additionally, interest rates are a common input in the stock valuation methods used by many investors. These methods include the Dividend Discount Model and Discounted Cash Flow. A stream of future cash flow is more valuable to an investor when it is discounted at a lower interest rate than when rates are high. While we don’t specifically use these models to value the companies we buy for clients, we are aware that they influence share prices. These models are good in theory, but in reality there are other problems with these models, including the difficulty of accurately predicting future cash flows.
Lastly, many investors look at income-oriented investments in addition to growth investments. At a high enough yield, a safe flow of cash from a bond becomes more appealing than the potential gains from a stock. Conversely, bonds hold less appeal when their yields are very low.
Consider the wild ride bond investors have experienced in recent years due to fluctuating interest rates. In spring and summer 2021, the Federal Reserve assured investors that emerging inflation was simply “transitory.” In fact, it was becoming embedded in the economy because the Fed and the government flooded the world with money in response to an unknown future during Covid. When the world economy started to improve, the excess money was difficult to mop up.
Belatedly, the Fed realized it was behind the curve and started to sop up extra money in late 2021 and into 2022. Short term bond yields rose, creating an “inverted” yield curve where short-term rates are more lucrative than long-term rates. This is typically a precursor to a recession, and stock prices plummeted accordingly.
High interest rates contributed to the bankruptcy of three major banks in early 2023 and put much of the U.S. manufacturing economy into a recession. High mortgage rates led to rising house payments, adding to consumers’ woes. But overall, the Fed did a masterful, if belated, job as high interest rates brought down inflation without killing the economy. However, we note that inflation remains higher than pre-Covid levels.
In the summer of 2024, the “real” inflation-adjusted Fed Funds rate was too high, and the Fed embarked on a series of cuts. The stock market took off in anticipation of these cuts. Fast forward a year later, and the Fed began cutting again as unemployment began to rise. The stock market soared almost two months earlier as investors anticipated the cuts. The potential for gains and the desire to avoid losses keep investors alert for factors that could lead to interest rate changes so they can reposition their portfolios in advance.
History shows that rate cuts usually lead to stock market gains as long as they are not accompanied by a recession. Although there are pockets of weakness in the economy at present, particularly surrounding people with modest incomes, the typical precursors of a recession are not apparent. Let’s keep our fingers crossed that the Fed cut rates in time.
Scott D Horsburgh, CFA®