Everything You Need to Know About Interest Rates

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Everyone is talking about interest rates, but you don’t really understand what they mean for you and your financial life.

The complicated definition of an interest rate is, the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding. But, you can just think of it as the cost of money.  

Debt is always an asset on one person or institution’s balance sheet and a liability on another’s. Your mortgage gets bundled up with other mortgages and sold to investors in the form of a bond. Bond investing is buying the debt of others.

How Interest Rates Affect You

You Work at Microsoft

1. The Fed needs to slow down growth to fight inflation.
2. So, investors sell the stock due to that slowdown.  
3. But Microsoft executives know they still need to provide value to their shareholders.  
4. That means they start to make cuts to preserve their cash and margin.  
5. And the easiest way to do that is layoff employees, and it happens to be you.

Rising Rates Harm Other Parts of Your Financial Life

1. The Fed raises rates to discourage borrowing and slow economic growth.  
2. At the same time you are expecting your second child and have to shop for a larger car.  
3. Cars are 20% more expensive so you will need a larger loan.  
4. And that loan will charge a 7% rate rather than a 3% rate, effectively causing you to pay more in interest.  

The Fed Stops Hiking

1. The Fed decides to end the hiking cycle.  
2. The market reacts favorably.  
3. You have been a diligent saver and have money in your 401(k).  
4. The market rallies 20% and your portfolio increases.  

Where People Go Wrong with Debt

People get in trouble or don’t get far enough down the road because they have too much debt.  

Take the US government for example. Every time the old debt comes due the US government has to refinance it with new debt. Forever indebted to its debt holders and can never move forward from it.  

This is fine for the US government, but not for you.  

In your life this can look like using your credit card to pay your mortgage payment.  

How Interest Rates Affect the Stock and Other Markets

Think of interest rates as a money black hole. The larger the mass (rate) the more matter (money) it can consume.  

In the previous cycle, from the 1980s-2022, interest rates were falling. Falling/low interest rates incentivize investment in other areas of the market to generate return.  

This was particularly important from 2008 to 2022. When rates were at near zero levels investors, us, had to seek returns in other areas of the market.  

The traditional portfolio, 60% stocks 40% bonds, shifted to 70% stocks 30% bonds to generate the return that people needed to live off of in retirement.  

Investors stretched risk to generate return and found income in dividend stocks.  

In the new cycle, and who knows how long it will last, the interest rate black hole is 400% larger than it was for the last 15 years.  

Allocators, like ourselves, look to make more investment in the debt markets to generate returns for older clients that need cash flow in retirement, effectively making equity market returns more challenging.  

Equity market investing isn’t dead, it will just look different.  

What Interest Rate Does the Fed Control?

The Fed controls the short end of the curve by manipulating the Federal Funds Rate. They send the rate higher the banks can either send money to the Fed or they can invest in the bond markets.  

If rates at the Fed are higher than the bond markets, the banks choose the Fed. When that happens market rates rise because there are less buyers in the market.  

Where Interest Rates Go from Here and How they will Affect You

We are nearing the peak of the Fed hiking cycle. That means that soon we will either see economic data that causes them to cut rates or not hike rates any further.  

The soft landing you keep hearing is the scenario where the Fed does not hike and holds rates steady.  

The most likely scenario from here is that rates stay flat or fall.  

Interest Rates Fall

When interest rates fall that generally means that the economy is entering, or is in, a recession. Because the economy is made up of companies, the S&P 500 suffers.  

Although the stock market is not the economy, the companies within the stock market are the economy.  

As you can imagine, because when rates drop, bond prices rise, this is a great scenario for bonds. With bonds you get starting yield plus the price appreciation from falling rates.  

What matters is the magnitude.  

Interest Rates Don’t Move

This is the most common environment. Most of the time no action needs to be taken with monetary policy.

In this scenario, the markets are fat and happy, because there is no uncertainty.  

Interest Rates Rise

When interest rates rise, generally the stock market is doing fine. As I said earlier, the stock market is not the economy, but the companies within the stock market are the economy.  

Interest rates needs to be raised because the economy is growing fast and causing inflation and that is a great thing for stocks.  

In 2022, the market had already priced in that growth in 2021, because again, the stock market is not the economy.  

This type of period is the worst for bonds because as rates rise, bond prices fall (because you can invest at higher rates and why would someone want your lower rate bond).  

Navigate Tough Interest Rate Environments with Fjell Capital

At only $125/month and 0.75% on assets we actually manage you can get access to a dedicated and heavily resourced team.  

The benefits are:

1. You can navigate with confidence.
2. Protect and grow your life’s work.  
3. Invest better.  
4. Learn how to make more money.  
5. And avoid costly financial mistakes, like having bad debt.  

As the times change, change with them. Stay nimble and move with confidence.  

Sources:  

Figure 1-3: Damodaran, Aswath. “Historical Returns on Stocks, Bonds and Bills: 1928-2021.” Historical Returns on Stocks, Bonds and Bills: 1928-2021, https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html.