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Back to the Fundamentals

Wall Street is fond of talking about the “fundamentals” of investments. This is especially true when their forecasts go awry, and their customers are left holding the bag with large losses. In an effort to shift the focus from faulty analysis, brokerage firms often fall back on the old cliché that the “fundamentals are still intact” even though the price might be struggling for altitude. Until recently, investors have seemingly ignored the most fundamental factor in finance: interest rates.

How fundamental are they? Unlike stocks, the history of interest rates goes back some 4000 years to ancient Egypt. Farmers developed a rudimentary concept of interest by requiring some compensation for foregoing current consumption when making loans of seed or livestock. In the Renaissance, dynasties were created by rich families willing to loan money to kings to fight wars or finance expeditions by sea or along the Silk Road. In the 18th and 19th centuries, the British empire expanded around the world at least partly due to their good credit and well-developed bond markets. Never in financial history have interest rates been successfully held down at zero permanently.

But modern central banks have tried. It’s no surprise investors have been lulled into a sense of complacency. Interest rates were held near the zero boundary for over a decade by the U.S. Federal Reserve’s money printing policy known as “quantitative easing” (QE). QE was designed to liquify the banking system and keep interest rates low, unnaturally so. From a temporary rescue program in 2008, QE morphed into the only monetary game in town. Artificially manipulating interest rates has become a long-term policy.

Investors have woken with a start, thanks to inflation, and interest rates have become the worry du jour for Wall Street. To understand why, it’s important to understand how interest rates affect investments.

With bonds, when interest rates fall, bond prices rise so that the interest payment one receives equates to the percentage yields prevailing in the market. Conversely, when interest rates rise, bond prices fall, again to bring percentage yields into line with (now rising) market yields. Bond prices and yields are inversely related, and this relationship can be represented as a playground teeter totter—as one side goes up the other goes down.

Stocks, too, have an inverse relationship with interest rates, though it is not as mathematically precise as bonds. Interest rates affect stocks primarily by their effect on the “present value” calculation by which future earnings are discounted back to the present day using an appropriate interest rate (the “discount rate”). As such, stocks and rates have a similar teeter totter relationship: the lower the discount rate, the higher the present value of today’s stock price. This is a key reason investors fret not only about market interest rates, but also the earnings a company can generate.

Thus, interest rates form the bedrock of finance, and they, in turn, are influenced by inflation. Inflation and interest rates are two sides of the same coin. At its most “fundamental,” lenders ought to require an interest rate equal to inflation to compensate them for foregoing consumption today. After all, the prices of goods, food, and energy will likely be higher by the time the loan is repaid, and so the future value of the loan must account for that. In other words, there is a time value to money. So in its most basic form, interest rates should approximate the rate of inflation.

Unfortunately for investors, today they are far apart. The latest Consumer Price Index reading was 8.5%, while as of this writing the one-year T-Bill yields 1.9% and the 30-year T-Bond yields 2.9%. This is an unprecedented gulf between interest rates and inflation.

The implications for investors are that interest rates are going to rise back up to where they should be on a fundamental basis. The Fed, and other central banks, have been caught napping as inflation has surged over the last year. They had plenty of warning that inflation indexes were rising, and inflation trends were well established even before the Ukrainian war sent commodities prices rocketing higher. Moreover, inflationary psychology is taking hold among consumers, who are now expecting inflation to remain high until further notice. Inflation, as we noted in previous Market Outlooks, is forcing the Fed’s hand.

Bond investors have taken matters into their own hands as it became clear the Fed has made a grievous mistake by falling way behind the inflation curve. Judging by this year’s weak bond market (losses of minus 7-9% so far), investors are already factoring in persistent inflation for the foreseeable future.

Market yields may rise for an extended period of time, or they may rise abruptly, as savers adjust to the new inflation reality. The poor returns on bonds this year reflect a very rapid recalibration of what investors are willing to accept for yields. Yields of all maturities have spiked higher, though off of a very low base. If we assume yields should approximate inflation, then the current chasm between the two imply that yields will rise quite a bit higher.

What are the implications of these new-found fundamentals of higher interest rates for investors? Aside from the “present value” effects of lowering asset prices, higher interest rates are affecting businesses and consumers from top to bottom. For prospective homebuyers, the leap in mortgage rates has increased monthly house payments required for purchase. With home prices scaling epic heights, this has priced the marginal buyer out of the market. We are starting to see some effect on home sales, with March home sales down 8% from the previous month, just ahead of the busy selling season. Investors should keep their eyes on the homebuilding market to track this “canary in the coal mine” of the U.S. economy.

Higher rates are also affecting financing on Wall Street. Margin debt, i.e. debt used to leverage brokerage accounts, fell 4.3% in March after peaking at record highs in late 2021. Margin interest rates are among the quickest to change, and brokerages are whooping with joy at their ability to raise them on the mountain of margin debt outstanding. This has been a very lucrative business for Wall Street firms, who have encouraged as much borrowing as possible. Of course, margin debt is a double-edged sword. It magnifies gains when prices rise, but also magnifies losses when stock prices drop. If rising rates continue to exert downward pressure on stock prices, then today’s high levels of margin may feed a downward cycle of stock liquidation.

For traditional savers, there is actually a silver lining to higher rates, as yields move higher (a bit) on money market funds and CDs. QE has victimized these people the most, as their returns were pushed to near zero by the Fed’s policies. Now, at least these savers can make a start to recoup some of the returns the Fed quashed.

Both stock and bond markets have awakened from their fantasy that low rates could continue forever. Stocks have matched bonds’ dour performance this year, with returns of minus 8-10% common. For those hoping this correction represents a buying opportunity, we would ask they look at two key market indicators.

The NYSE advance/decline (a/d) line measures the broad trend of whether most stocks are going up or down in price and is an egalitarian indicator in that each stock gets “one vote,” unbiased by market-capitalization weighting schemes (e.g the S&P 500). The message from the a/d line is one of caution. Both the daily and weekly (shown) calculations show clear downtrends. Despite some upside index bursts that get everyone excited for a bottom, the a/d line shows that the majority of stocks are grinding lower. We advise stock investors to become aggressive buyers only when the a/d lines give buy signals (which we will highlight when it happens).

The second indicator, the NYSE Bullish %, looks a little more promising.  This measures the percentage of stocks on point-and-figure buy signals, and like the a/d line, is a measure of “breadth” of price trends.  The late March market rally pushed the Bullish % to a buy signal, but it has quickly reversed to a column of Os implying current weakness.  However, this is how declines are reversed, though it looks more likely the Bullish % will get to oversold levels (< 30%) before a bull market gets started in earnest.  Given the suspiciously quick reversal into Os (i.e. weakening) we would caution investors to wait for a reversal up (X column) before making broad buying commitments.

Rising interest rates have now become top of mind for investors as inflation takes hold.  The Fed’s efforts to suppress interest rates has led to mindless speculation, excessive debt, and widening social inequality.  Importantly, the Fed has barely begun tightening monetary policy, so the most serious effects on the markets may not yet be felt.  However, interest rates that correctly reflect inflation are fundamental building blocks to investing and sound money, and we should welcome their return.  It looks like the era of artificial interest rates is coming to an end.