Why Does the Market Care About Interest Rates?

We’ve experienced what are typically entire year-long returns and volatility in the span of a week.

Just when we thought we were through the wackiest and wildest period for markets, we’ve been rocked with another absolute bombshell of a sell-off in all growth names.

This doesn’t happen randomly, and cannot be evaluated in a vacuum.

The #1 on everyone’s hitlist these days seems to be the high-growth unprofitable tech:

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After putting up phenomenal returns in 2020, 2021 was a period where these stocks mostly traded sideways, and now we’re having a sharp downturn to start off 2022.

But I thought “everything shifted online?” and the “Metaverse will dominant the market!” While the fundamentals for many of these companies are improving, you have to take into consideration the largest factor in the stock market: The flow of money.

And what dictates this flow of money? The Fed. How can we gauge the “Temperature” of this money? Interest Rates.

In this issue, we’ll discuss what’s happening with the great rotation from growth stocks into value stocks, what the role of the fed is in all of this is, and how we can use interest rates as a barometer for how these changes occur.

This week, in <5 minutes, we’ll cover the impact of the Fed’s recent actions through:

  • The Fed and its Role in the Economy  👉 The Invisible Hand that Guides
  • Quantitative Easing, Tightening 👉 How Money Supply Affects the Economy
  • Interest Rates 👉 Hawkish, Dovish
  • Factor Rotation 👉 From Growth to Value

Let’s get started!

1. The Fed and its Role in the Economy  👉 The Invisible Hand that Guides

The Federal Reserve System (or the Fed) is the central bank and monetary authority of the United States. Its role is to provide a safe, flexible, and stable monetary and financial system. Their main duties are conducting monetary policy, regulating banks, maintaining stability, and providing banking services.

The system is made up of 12 regional federal banks that are based in these regions:

Fed System Banks

The Fed also must be independent of any political agenda so it serves the function of fiduciary responsibility rather than pandering to alternate agendas. They meet eight times a year, which roughly translates to about every eight weeks to make a press conference where the Fed Chair reads a statement that updates the world on his or her view going forward. The meeting minutes are released before the actual event and every economist pours through them looking for minor wording changes to get a hint on how policy can be formed.

The two monetary policy goals of the fed are to achieve stable prices (AKA control inflation) and to achieve maximum sustainable employment. If you think about it these are incredibly important goals.

In the period of the Coronavirus, we had massive supply chain disruption as well as many people unable to work due to contact with the virus. These are the two biggest economic issues right now and also the two that the Fed is primarily responsible for. Heavy task…

The Fed also serves a much broader role in the global financial economy. Since the United States is seen as the benchmark for how to operate a free market economy, the rest of the world looks to the U.S. for guidance. On top of just “guidance”, the U.S. Dollar is widely considered the world’s reserve currency due to the historical track record of sound economic policy and a little agreement called the Bretton Woods Agreement.

Since the U.S. Dollar is the world’s reserve currency, the way they set monetary policy influences the rest of the world through strength/weakness in the dollar. Since central banks (the Fed) control the money supply, we have to understand how this affects interest rates.


2. Quantitative Easing, Tightening 👉 How Money Supply Affects the Economy

The Fed controls the money supply through printing paper money, setting reserve requirements for large banks, setting the federal discount rate (the rate at which commercial banks get to borrow from the central bank), engaging in open market operations (selling or buying government securities like government bonds).

Money demand is the proportion of their total assets that people are willing to hold in the form of money. They get compensated for holding this money in the form of interest rates, and they take the risk of holding this money in the form of inflation, which reduces the purchasing power of money.

The intersection of the money demand and supply curves largely dictates the interest rate as well as the quantity of real money holdings in a market equilibrium.

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There are two terms that are popular to describe the control of money supply: Quantitative Easing and Quantitative Tightening.

In times of dire economic stress, central banks take open market operations to institute a program of quantitative easing which is an expansionary monetary policy. The Fed did this, most popularly first in the financial crisis of 2008. They create money then use it to buy up assets and securities like government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The banks’ reserves swell up by that amount, which encourages banks to give out more loans, which further helps to lower long-term interest rates and encourage investment.

Quantitative tightening (QT) is just the opposite and is a contractionary monetary policy. It’s when a central bank steps in with the goal of normalizing (raising) interest rates in order to avoid runaway inflation. They do this by increasing the cost of accessing money and reducing the demand for goods and services in the economy.

Both of these measures were widely unused up until 2008. We did see some QT in 2018 as the Fed began retiring debt on their balance sheet, which was reversed in 2019 when the Coronavirus hit.

But first, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!

3. Interest Rates 👉 Hawkish, Dovish

When people usually refer to the “Interest Rate”, what they are referring to is the U.S. 10 year Treasury yield (AKA the 10yr). The 10yr is debt obligation that is issued by the United States government with a maturity of 10 years from issuance. This note pays a fixed rate twice a year and pays the principal of the note back to the holder at maturity.

The 10yr is so important because it is often used as a benchmark for lending across the entire credit market. For example, if you go to get a mortgage you get quoted on a rate +/- the benchmark rate (the 10yr).

The 10yr rate is dictated in live time and acts in a free market, meaning large institutions can trade the underlying asset and the rates are dictated by supply and demand just like anything else.

A rising yield indicates falling demand for treasury bonds, which means investors prefer riskier assets where the return profile is more attractive, while a falling yield suggests the opposite. This rate acts as an indicator of investor sentiment in the economy.

When the Fed is putting on pressure to raise interest rates (contractionary monetary policy), they are said to be hawkish = risk-off. When the Fed is putting pressure to lower interest rates, they are said to be dovish = risk-on.

The rationale behind this is the trade-off. Why would I park my money somewhere that is only yielding 1%, when I can invest in riskier assets that can raise my return?

A common proxy that a lot of people look at is the S&P500’s earnings yield (yellow) vs. the 10yr (white).

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If we look historically, there has been a leadership change a couple of times over previous decades that made the case for a lot more demand for fixed income as the yield was available in the debt market. However, there has been a regime change since the Dot-com era and some argue that after excessive QE in 2008, we may not see the white line get back above the yellow one. Time here will tell, as we enter the next “rate-raising” environment over the coming years.

4. Factor Rotation 👉 From Growth to Value

The reason why a big rotation has occurred is largely due to the increase in interest rates… but WHY…

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A common method used in security analysis is called a discounted cash flow (DCF) model. What this does is value an investment based on the future cash flow return profile that can be generated and “discounts” them back to the present. The formula is:

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The “r” referred to in this model is typically the company’s weighted average cost of capital (WACC) where the formula is:

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We won’t go into too much detail in the above, but for the purpose of this discussion, we will assume that everything in the above formula remains the same except for Rd AKA cost of debt. Since we know the 10yr is used as a benchmark for the cost of debt, we can say that the higher the Rd, in the WACC calculation, the higher the r in the DCF model.

Going back to the DCF model, we know that a higher denominator = a lower DCF value:

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BUT since a high-growth company typically is a longer duration asset (cash flows are pushed out to future dates), the exponent next to (1+ r) in the equation discounts those later (higher) cash flows at a much steeper rate. Let’s walk through an example:

Here we have an Oil Co. and a Tech Co. growing Cash flow at 5% and 25% respectively over 10 years. You can see that the ending DCF valuation for the higher growth Tech Co. falls 26.8% relative to this Oil Co. Which only fell 19.7%. Bad for both companies, but as you can see the more pushed out the cash flows (typically as the tech company reinvests in product and growth in early-stage), the worse off the present value is.

We can monitor this move by the relative performance of the growth (yellow – VUG) vs. value (White – VTV) rules-based ETFs:

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Although this is one of the factors for the recent explanation in the rotation from value to growth there are other solid arguments as well such as mean reversion of multiples to historic means, less money “in the system” that crowds around growth (AKA flow of funds), large redemption from active growth managers exacerbating the downturn, the comeback of the “real” economy, and so on and so on…

The main takeaway from this massive selloff is that although you can understand an individual company inside and out, just as “dont fight the fed” is the mantra in an expansionary policy, it is also the mantra in a contractionary one.

Wrapping Up…

There are, of course, a lot of different moving pieces in place right now. We’re in the mostly unchartered territory after the historical expansion of the Fed’s balance sheet. Some economists are starting to wonder what impacts deflationary technology will have and question whether we will need to infinitely expand the Fed balance sheet as a new normal. Some question whether the Fed has any control at all over inflation.

There is much to debate, and even more to try to understand, but the number one takeaway from this is that it is not as simple as drawing an economics diagram with supply and demand curves, then finding an equilibrium. Everything is in constant flux and it’s very important to understand these broad-reaching implications.