The Effect of an Interest Rate Increase on the U.S. Market

Highlights

• What it means when the news media reports an interest rate change 
• The potential impact of a higher interest rate on the U.S. market
• Lincoln Capital’s perspective regarding investments in the short-term

Estimated read time: 5 mins

With the Federal Reserve raising interest rates for the first time since December 2018 (and recent market volatility caused by this anticipated change in policy), it’s reasonable to wonder, what interest rate are we talking about?  And how do interest rates impact the stock market?

The Interest Rate = The Federal Funds Rate

The interest rate in question is the Federal Funds rate controlled by The Federal Reserve (simply known as “the Fed”), the central bank of the United States. The Fed Funds rate is the interest rate charged to borrow (or lend) excess reserves overnight. The Fed has historically used it as the primary tool of monetary policy for “cooling” (by raising rates) or stimulating (by lowering rates) the U.S. economy.

Theory holds that there is an equilibrium Federal Funds rate that neither stimulates the economy nor restricts it. Since the Fed will be lifting rates from near 0%, we are a ways off from reaching this equilibrium level. This can be thought of as lifting your foot off the accelerator, rather than actively applying the brake.

The Fed Funds rate indirectly influences long-term rates via the Expectations Theory―that long-term rates are driven by the market’s expectations of future short-term rates. For example, if the Fed raised the Fed Funds rate to restrict the economy (causing a recession), then short-term rates in the future will likely be lower. In this scenario, a long-term bond rate could be below short-term rates (the infamous inverted yield curve). Short-term rates directly influence banks and those borrowing with adjustable interest rates. Longer-term rates impact commercial and industrial loans, car loans, and mortgages, to name a few. 

Historically, the Fed did not interfere directly in long-term rates; however, this is now common practice via quantitative easing (buying bonds across the maturity spectrum). As the Fed gradually stops asset purchases via quantitative easing, long-term interest rates may rise as demand drops.

The Impact of Interest Rates on the U.S. Market

To determine the impact of interest rates on equity prices, there is a mathematical approach and a qualitative approach. We’ll explore each of these methods.

The Mathematical Model ─ Decreased Asset Valuations Possible, Not Certain

Using this approach, any income-producing asset can be valued by discounting all future cash flows. For example, a bond pays a known coupon payment and returns a known principal value at maturity. The major unknown in fixed income pricing is the reinvestment of coupons received before maturity. If interest rates rise, the price of the bond today has to go down since all other inputs (coupons, principal amount) do not change.  

Equities are trickier. Equities are valued as the sum of future free cash flow to equity holders.   Put another way, it’s the cash flow remaining to the owners after cash expenses, debt payments or receipts, capital expenditures, and changes in working capital are paid. A simple equity valuation model is the Gordon Growth Model, which takes a strict approach to cash flows and only includes dividends paid to owners. The formula for the Gordon Growth Model is:

Where variable D is the dividend expected next year, R is the rate of return required (this is usually based on the intermediate term risk free bond rate and a risk premium), and G is the long-term growth rate of the dividend. For instance, for D = $1.00, R = 10%, G = 3%, the price of the security would be $14.29.  

So how would interest rates impact the equity’s value? Variable R would increase, putting downward pressure on the price. However, what about variable D or G? Ultimately it depends on whether the level of interest rates is restrictive or stimulative. Today, the economy and corporate profits are strong, prompting the Fed to start raising rates. The competing influences of higher future dividends and higher interest rates will make determining the impact on price difficult.  We believe the Fed will not be hiking rates into restrictive territory (i.e. past the equilibrium level) insulating security prices from tightening policy in the short to intermediate term.

The Qualitative Model ─ Back to Fundamentals

There is a large cohort of yield-seeking investors or investors required to hold fixed income securities━retirees, banks, pension funds, and insurance companies. When interest rates are too low, these investors must venture into other asset classes in search of returns. This often starts from moving from treasuries to investment grade corporate bonds, corporate bonds to high yield, high yield to dividend-paying equities, and so forth. The low interest rate environment has forced many of these participants to take more risk than they would have otherwise.

As yields on treasuries and investment grade corporate bonds go higher, this set of investors would become sellers of riskier assets and buyers of safer assets. This dynamic has the potential to lower equity prices as a result. As mentioned in the mathematical model, this doesn’t happen in a vacuum. If rates are rising because the economy and corporate profits are strong, the selling pressure is countered by improving fundamentals.

Our Take: Equities to Withstand Rate Hikes in the Near Term 

In summary, while it would satisfy most if there were an iron clad rule that higher rates cause lower prices; unfortunately, reality is too complex. Whether higher interest rates are helpful or hurtful depends largely on the strength of the economy and the level of interest rates. 

In the very near-term, the conflict in Ukraine will likely be the main determinant of stock market volatility. As the conflict settles, we expect Fed policy to regain primary importance.

This aligns well with a recent analysis done by The Bank Credit Analyst, suggesting that stock returns are best when policy is loose, while economic data is best when rates are rising and not yet restrictive. Although rising, we believe that interest rates will remain accommodative for at least the next 18 months and investors should stick with equities.

About the Author

Sean McGuirk is a Chartered Financial Analyst® for East Greenwich-based Lincoln Capital, a financial planning and wealth management firm. He is a graduate of Bentley University and a board member of the CFA Society Providence.