The Fed, Interest Rates And Stock Prices: Fighting The Fear Factor by Aswath Damodaran, Musings on Markets
If it feels like you are reading last year’s business stories in today’s paper, there is a simple reason. The Federal Reserve’s Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.
- The Fed sets interest rates
Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries.
Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don’t have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates, that link becomes much weaker when we look at long term rates and their derivatives.
Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..
- Low interest rates are the Fed’s doing
Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!
Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed’s own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:
Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate. In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.’
To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed’s exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration.
Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.
- The reason stock prices are so high is because rates are low
Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse.
Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007.
At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in