So, About This Rate Hike…
By Brad Thomason, CPA
December 16th is right around the corner. That’s the day the Federal Reserve will raise interest rates for the first time in forever. Or else, they won’t. Prognostication is running high. We will not attempt to add to it here.
Instead, let’s take just a minute to think about why this matters to many investors. It actually doesn’t have much to do with the rates themselves. Wall Street and its devotees are following the story because of the impact that interest rates have on stock movements.
There’s an old adage on Wall Street: “When rates are low, stocks will grow.” Why? Well, a couple of reasons. The first has to do with the rates as seen from the perspective of the borrower, that is, the corporations whose stocks trade on the exchanges. If you can borrow money at a lesser rate then you can keep more money going to the bottom line. It’s a classic cost-cutting play. Since earnings drive stock prices, higher expected earnings is good, and stock prices rise. Or, as a variation on the theme, instead of letting the cost savings fall through to the bottom line, the company might use the opportunity to expand. With rates lower, they can service more debt for the same interest expense, and use the extra capital to add more earning capacity to the company. Either way, lower rates lead to higher earnings because of the way they impact the company’s debt management options.
Low rates also help stock prices a second way. Despite there being quite a few alternatives out there, it is still the case that most US investors hold (directly or in funds) just stocks and bonds. When rates are low, new bonds don’t pay much. Not content with lower yields, many investors reallocate and go heavier on stocks when these conditions exist. More people buying the same number of stocks equals price increases. It’s plain, ole supply-and-demand.
So it is not hard to understand why low rates can be good for stocks, and low rates have certainly been part of the story as stock prices recovered after the financial crisis and then kept going into new territory since.
Interestingly, several times this year, the stock market has rallied when there were indications from various members of the Fed that a rate hike could take place before year end. Seems the market likes the idea of higher rates, too.
The general case for a rate hike is that it would indicate a healthy economy. A healthy economy means one in which people have the money to buy stuff. Buying stuff leads to higher corporate profits. Which, of course, drive stocks higher.
To summarize: the stock market has reasons to like low rates and reasons to like rising rates. The stock market is, in theory, an interpreter of earnings prospects. And since it is plausible that earnings could rise under either condition, you get this seeming paradox which really isn’t a paradox after all. Lots of factors impact earnings. The direct impact of low rates may or may not be greater than the indirect impact of more customer activity. It’s a fair bet, either way.
Which, in the end, makes me wonder just how much difference the Fed’s actions are going to make to the market, one way or the other. Guess we’ll have to wait and see.