The Role of Interest Rates in Investing


John Micklitsch, CFA CAIA, Chief Investment Officer

With so much attention on inflation, the Fed and interest rates these days, we thought it would be helpful to discuss the role interest rates play in investments. Interest rates essentially represent the cost of money; higher interest rates raise the cost of money while lower interest rates reduce the cost.

The Federal Reserve sets the federal funds rate, which impacts short-term interest rates, or the short end of the curve (short and long-term rates are frequently referenced along the spectrum of the “yield curve”). The market, absent Fed intervention, sets intermediate and longer-term rates via investor sentiment around things like the outlook for the economy, interest rate speculation, inflation, etc. When the Fed wants to slow the economy down, they raise the cost of money and, when they want to speed it up, they lower the cost. Right now, it looks as though the Fed is becoming more concerned about inflation and the economy overheating than the risk of the economy falling back into a recession, so they may begin to raise the cost of money.

Interest rates also impact investor’s appetite for taking risk. In general, a lower interest rate environment induces risk taking, while higher rates tend to make lower-risk investments just a bit more attractive to investors, at the expense of equities and other risk-seeking assets. This is mainly because the forward return on risk-free investments such as Treasuries (held to maturity) goes up when rates rise, allowing investors to get an improved return with low risk. The flip side is that when interest rates are low, the returns on conservative investments are not enough to satisfy many investors. We like to say that every dollar needs to find a home somewhere, so there is a constant tug of war between conservative and riskier assets that is frequently influenced by the level of interest rates.

Lastly, interest rates impact asset valuations. Lower interest rates tend to drive up asset values and higher interest rates tend to lower them. Think about housing prices and the affordability factor that comes with lower mortgage rates. Or think of the S&P 500 as a single business which you personally own 100% of and therefore could control the distribution of earnings. The S&P 500 currently trades at approximately a 20x price to earnings ratio. Looked at the other way around, a 20x P/E ratio equates to a 5% earnings yield ($1 of earnings / $20 price). So, when the alternative for that dollar is to invest in things like Treasuries with lower yields, generally speaking an investor would be willing to pay more for investments like equities, provided their earnings yield and growth outlook is sufficient to compensate for the risk associated with owning a business versus simply lending to it.

While we expect to continue seeing much discussion over the direction of interest rates in the coming quarters, which could result in increased episodic market volatility, it’s important to remember that in an absolute sense, interest rates are likely to remain low from a historical perspective. In addition, the economy continues to recover, liquidity remains robust and the corporate earnings backdrop remains solid, in our view. It’s important to consider all these factors, including the concept that every dollar must find a home somewhere, in the context of your long-term allocation and investment decisions.  

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