The Landscape

The Anatomy of a Rate Hike

Inflation. The word alone makes the Federal Reserve sit up and take notice. According to its mandate from Congress, the Fed is put in charge of minimizing inflation while maximizing employment. These two goals often conflict with one another. A tight labor market causes wages to rise, which pushes up the cost of doing business, which raises prices, which is inflationary. 

The Fed is put in charge of managing inflation, and its primary tool for doing so is to set the interest rate that banks charge each other for Fed funds overnight. Since banks are for profit businesses, they must charge more to lend than they pay to borrow. That means if the cost of funds rises, the bank has no choice but to pass on the increased expense to the consumer. That part is pretty easy to understand. But why does a rising interest rate siphon capital out of the stock market?

First, money is fungible. It is easy to allocate capital to one investment, only to convert it back to money and then into a different investment. Since this can be done multiple times with no loss of quality or quantity, investment money will search out the highest return, within reason. But a return comes with a caveat. Risk. The higher the imputed return, the greater the risk because nobody would willingly put their capital at increased risk unless they were compensated for doing so. 

Capital will flow where it achieves the highest risk adjusted return.

If we start with the premise that an investor will always try to achieve the maximum return when adjusted for risk, you can easily see why a rising interest rate is bearish for the stock market. Let’s dig in. 

First, let’s accept the fact that for all intents and purposes, US government bonds are basically risk free when it comes to their ability to pay back the nominal amount that they borrowed. While it is true that they do not pay back with dollars that have the same purchasing power, they do have the ability to print money, if necessary, to pay its obligations. Such is one of the benefits of having the world’s reserve currency.

Since government bonds enjoy such a solid reputation for being risk free, their interest rate is the gold standard that other investment ideas are measured against. If US government bonds are paying 4% returns risk free, then any business worthy of investment must return AT LEAST 4% to justify acquiring the additional risk that accompanies equity investment. 

Bonds compete with stocks for investment dollars.

The above paragraph makes perfect sense if you think about it. If you as an investor are given a choice of earning a sure 4% vs a potential 4%, which are you going to take? The answer is pretty easy. But what if you could earn a sure 4%, or a possible 10% return by taking on some risk? Suddenly, the choice isn’t so easy. 

Investors are constantly analyzing their options and measuring the potential return of one investment against another. The higher the risk-free return becomes, the more profitable a company must become to remain attractive to investors. When government bonds were trading at 0% interest, any profit, no matter how small, that a company could derive was something worth considering. But as rates rise, the dynamic changes. 

A rising interest rate harms the least profitable corporations first. The low margin corporations that don’t clear their minimum amount of profit to cover their expenses. No investor would want to hold shares in a corporation that isn’t profitable when they can earn a sure return by holding government bonds. Since capital money is fungible, it can easily flow out of bonds and into stocks, and vice versa. 

As the Fed raises rates, investors are able to earn a higher nominal rate, essentially risk free. This rising interest rate is a potential return for an investor, and the higher the risk-free return is, the more a wise investor will require from the stock market before they consider parting with their hard-earned dollars. 

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