The Federal Reserve’s policy decisions have immense effects on stock prices. The financial news regularly reports on Fed policy decisions, and “don’t fight the Fed” has become a standard aphorism for nearly every market strategist. Despite this coverage of Fed policy, few investors seem to understand the mechanism by which the Federal Reserve impacts stocks and other risky assets.
Before continuing, we should note several things. First, the Federal Reserve has several responsibilities. However, for the investor, the key concern will be the Fed’s influence on the price and availability of credit. Second, the Fed is not the only economic force influencing stock prices. Fiscal policy, i.e., tax, spending, and regulatory policies, can significantly impact investor expectations. And there are always geopolitical factors at play that can rattle markets. Economists use the Latin term ceteris paribus (all else being equal) when looking at the impact of different variables. Thus, we will assume that all other influences are held constant.
Generally, a stock’s price can be considered a function of two variables: future discretionary cash flows of the underlying business and a rate used to discount those future cash flows to the present. It is primarily on these two variables that fed policy works.
Sales, expenses, and capital expenditures drive a company’s discretionary cash flows. Sales represent the primary variable in forecasting cash flows, as investors generally model expenses and capital expenditures as a percentage of sales. To the extent that a company’s sales are influenced by fluctuations in the economy, the Fed can affect sales and cash flow forecasts. When the Fed signals an increase in interest rates, investors recalibrate their near-term forecasts downward. When the Fed signals a decrease in interest rates, investors revise their near-term forecasts upward.
The discount rate is the risk-adjusted rate used to convert future cash flows into a single, current value. When computing stock values, investors use the interest rate on government bonds and then add an appropriate risk premium. Most thoughtful investors I know use the rate on the 10-year as their base rate. The various ways investors compute the equity-risk premium is beyond the scope of this post. For now, we can recognize that given a fixed risk premium, a change in the base rate will impact stock values.
When the base rate, and by extension the discount rate, increases, then the present value of the company’s future earnings will decrease. When the base rate falls, then the present value of the company’s future profits will increase. This same mechanism happens with bonds. Suppose a corporate bond is issued with a 5% annual coupon, meaning that at par ($1000), the bond pays $50 at the end of each year. If interest rates increase and investors can buy a similar bond at a rate of 7%, what would happen to the price of the first bond? Suppose the first bond has five years left until maturity. In that case, the bond’s price is (a) the present value of five $50 payments discounted at 7% and (b) the present value of the $1000 principal paid at maturity. The sum of these two values is $918, meaning that the bondholder is sitting on a value impairment of $82 (this loss is not realized unless the bondholder sells the bond). We can also observe the decline in the value of commercial real estate as interest rates rise. What’s important to note is that all else equal, the value of a future benefit is inverse to the direction of interest rates.
How does the Fed Influence Interest Rates
The Federal Reserve influences the supply and availability of credit by targeting a key interest rate known as the federal funds rate. The federal funds rate is the rate banks charge each other on overnight loans. The Federal Open Market Committee – a group of the seven federal reserve board members and five regional bank presidents – decides at scheduled meetings throughout the year what this rate should be.
At their core, commercial banks take in deposits and make loans to households and businesses. However, banks do not lend out all the deposits they take in for obvious reasons – they need to satisfy withdrawals from depositors. Banks keep some of these withheld funds as currency held in their vaults. The more significant amount, however, is held in the form of reserves. Banks that are members of the Federal Reserve system hold these reserves in accounts at their respective federal reserve bank. For example, a bank domiciled in Florida would have an account at the Federal Reserve Bank of Atlanta.
Banks can lend reserves to each other through the federal funds market, which is why the rate on these loans is called the federal funds rate. When we hear that the Federal Reserve “creates” money, it is effectively these reserves that they are creating through a process known as open market operations. The process works as follows. The Federal Reserve Bank of New York has numerous primary dealers – large banks and other financial institutions – with which they transact. Under the direction of the Federal Open Market Committee, the NY Fed can purchase or sell securities to these primary dealers. When the NY Fed buys securities, they pay for them by increasing the reserve accounts these dealers hold at the NY Fed, thus increasing the supply of reserves in the banking system. When the NY Fed sells securities, the dealers pay for them via a reduction in the reserve accounts, thus reducing the supply of reserves in the banking system.
Interest Rate Policy Before and After the Financial Crisis
Before the financial crisis, the Fed would achieve its target federal funds rate through open market operations. By purchasing or selling short-term treasury securities from primary dealers, the Fed could influence the supply of reserves and, by extension, bank lending.
The Fed’s response to the financial crisis resulted in a massive influx of newly created reserves into the banking system. Excess reserves, the reserves in excess of legal reserve requirements, went from being negligible to the majority of bank reserves. The Fed’s primary tool for targeting the federal funds rate changed during this new regime. In 2008, Congress gave the Fed the ability to pay interest on bank reserves held at Federal Reserve Banks. The Fed thus began to use interest paid on reserve balances as its primary tool. Because the interest the Fed pays is essentially risk-free, this rate places a floor on the amount of interest banks would charge on federal funds. In other words, when the Fed wants to increase the federal funds rate, it increases the rate paid on reserves. It decreases the rate paid on reserves when it wants to lower the federal funds rate.
How Stock Investors Should Think About Interest Rate Risk
The good news is that small changes in interest rates shouldn’t worry long-term stock investors. However, during the roughly 10-year period when credit was abundant and short-term rates were near-zero, serious investors should have used historical averages for their base rates rather than using then-prevailing rates on the 10-year T-Bill. As the old saying goes, if something cannot last forever, it won’t. Using conservative assumptions when forecasting cash flows is another way of managing interest rate risk. These two guidelines, using normalized interest rates and conservative cash flow forecasts, allow investors to integrate valuation disciple into their process.
