Part 1: How Interest Rates Effect Asset Prices & Overall Economy

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Synopsis
Low interest rates push investors typically looking for yield into riskier investments. How will sudden increased interest rates effect asset prices and the overall economy? Part 1

Full Transcript

How Interest Rates Effect Asset Prices and Overall Economy

Moderator:
Good morning Sizetraders, Amos here. How is it going? I’m here with Gary, head trader at SizeTrade. Gary, are you with us?

Gary:
Yeah, how are you doing?

Moderator:
Good good Gary. We’ve been getting a lot of questions on interest rates. The Federal raised interest rates in December and we saw after the election, that the 10 year increased roughly around 100 basis points from 1.5% to 2.5%. So the question that we’ve been getting from a lot of our users is, how do interest rates affect asset prices and overall economy?

Gary:
Wow, that’s a really good complicated question.

I believe that interest rates are probably the most important thing that affects asset prices and overall economy right now in the markets. I think it’s been the most important thing in the last 5 years; ever since the crisis and QE.

Moderator:
So you think it’s even more important than how well companies are actually doing?

Gary:
I think it’s not more or less important, but I think that, right now, it’s driving asset prices, which drives companies to decide what to do with their free cash. How to invest their free cash is all based on interest rates so I think the driving force behind how corporations act and, at the end of the day, how much EPS they have, how much money they make and where their stock prices go, is dependent on interest rates today.

To answer your question, I really do think that interest rates are probably the most important topic out there right now. I guess I’ll just get into it.

Moderator:
Yeah, let’s get into it.

Gary:
So it all started basically with the crisis. I mean, a lot of things started with the crisis, but it basically goes back to the crisis and the Federal Reserve’s (FR) idea of quantitative easing, which was basically buying 10 year bonds on the open market, pushing up prices and pushing down interest rates and yields. It was the first time that it was done, in the US at least. There was a QE done in Japan in the late 90s, early 2000s. That basically pushed out interest rates to historically low levels. They’ve never been that low. The FR cut the interest rate to 0%. After that didn’t stimulate the markets, they basically came in and said, ‘’ hey, we’re going to do bond purchases. ‘’ They did it for around, I believe, 4-5 years. They became the number one buyer on US bonds during that time. What they were able to do was push down interest rates.

The concept is that when you push down interest rates, it does a couple of things. The first thing is that it hurts savers. So it forces people and corporations that are saving cash to invest that cash because they need to make some type of return on it.

Moderator:
So you’re talking about people who are looking for yield.

Gary:
Exactly. Well, everybody, right?

If you have 100 million dollars in the bank as your corporation, you’d rather make 2% or 3% on that money than 0%. That goes into your numbers. So if you’re making 2% on a hundred million dollars of cash, you’re making an extra 2 million per year and that goes too your bottom line. When you’re getting 0, you’re not getting any help from that.

Moderator:
I guess what I was trying to say were people looking for yield rather than investment purposes like stock, for instance. They’re looking for the appreciation of the stock or they’re looking for dividends as apposed to appreciation of stock.

Gary:
Well, I think it comes down to that in capitalism systems, we always make a choice. We’re always looking for opportunity cost. So, if interest rates are very high, like they were in the early 80s at 20%, the question is can you take that money that is sitting on your balance sheet or borrow money at 20% and turn that into some type of positive for you corporation. So if you’re borrowing at 20%, you probably have to fill comfortable that you’ll make at least 20%, 22% back on investment for that to make any type of sense. Some people will say that they need to forecast at least 30% so that, if it doesn’t work out, I get paid for taking that risk. So if you do the opposite and it shrinks down to 0%, all of a sudden, taking a risk and trying to make 1% or 2% only is a positive versus just keeping cash at 0%.

Unfortunately, it didn’t quite work out the way that the FR was hoping. They were hoping that companies would borrow money at very low interest rates and push it into the economy. That didn’t work out. So what happened is that, firstly, you push pension funds, which are big buyers of the markets. Also, you push individuals who buy yields, retired people and senior citizens who need yield to survive on, into riskier assets. If somebody needs a 3% yield per year to survive, let’s say they have $100K and they need an extra 3000$ above what they’re making on their pensions or whatever to survive and 10 year bonds are giving you 1%, that’s not enough for them. So now, you’re pushing them into riskier assets, which obviously have higher yields. So the riskier assets have always had higher yields. So the treasuries are considered risk free and everything is therefore priced off of that. AS the 10 year bond goes down, the spread between risk-free and something that is considered triple A, which is a little bit riskier than government bonds but not super risky like IBM, Apple; these companies that are making tons of money and default risk is low, they trade at a small spread between the treasury bond deals and the corporate deals.

So if the treasuries are giving you 1%, those bonds might be giving you 2%. It pushes these people looking for 3% to find it in riskier assets. Instead of doing it risk-free with a treasury, they went to AAA corporate bonds. Maybe it that wasn’t enough, they went to AA corporate bonds. The people, who needed 5% and usually got that from AAA bonds, went to riskier things like stocks with dividends paying 5%. All of this pushed in huge amounts of cash into these markets where these people wouldn’t typically invest in.

Moderator:
So the idea is to actually get investors into the market, rather than putting their money into safe places like bonds.

Gary:
Exactly.

Moderator:
To get the market stimulated and moving.

Gary:
Right. I think a lot of people had their money in sittings with banks. I think that easier than buying treasuries. But, that’s based off of the treasury price. So what happens is that when your bank was paying you 3% if you left your money in for 7 years, people are willing to do it because they trust their banks.

Moderator:
Right.

Gary:
The problem is that, as interest rates went down, those banks could no longer afford to pay 3%. So now, they start paying 1% on those sittings or in the bases points, like 30 or 60 bases points. And, that only happened not to be enough for these people so they wondered how they were going to get the yield and you have to go to riskier assets, like stocks that pay dividends. All of a sudden, you have this cash flow that went into all these companies, stocks, bonds etc and all of these prices are overpriced because there was a shier of demand coming in where these people didn’t really care about the asset price, but more about yield.

Moderator:
I was just about to say that a lot of these dividends paying stocks have outrageous prices because a lot of people are looking into getting into them looking for yield.

Gary:
Right, they’re trying to get really high PE ratios. Part of it is because if you’re an elderly person, you don’t really care if you buy a stock and it doubles or triples. I you care about is that you make sure they keep paying their dividends and that you’re getting some type of yield out of that money. So if you have a million dollars and you need to make 5% per year, which is 50 000$ per year, you’re just going to buy a stock that yields 5% and has what you think is a pretty secure probability of paying that dividend.

No you don’t really care if your principle goes from a million to 750 thousand or to 1.5 million, because you really care about earning that 50 000$ per year to cover your expenses; your rent, mortgage etc.

Moderator:
But, doesn’t the stock price and performance actually effect whether or not dividends are paid?

Gary:
Well, yes. So you have a situation where, if stock prices drop a lot, companies looking for cash could cut the dividend. But, again, utilities typically don’t cut dividend. Good quality companies are usually very reticent to cut dividend because they understand that a lot of their basis in the stock for that dividend. So if they cut the dividend, it’s going to force these people to sell and go find a different place to get what they’re looking for.

So, typically, what will happen is that you have a 5% dividend on 100$, the stock goes down to 50, dividend goes up and people begin to worry that this company is paying a 7 to 10% dividend and it’s not reasonable. The reason why they’re paying this much is because people are assuming that they’re not going to be able to continue to pay their dividend.

So that’s why a lot of times, dividend stocks are less sexy. They don’t appreciate as much. But, in bad times, they don’t go down as much. Defensive stocks are considered high dividend yield paying stocks, like Telecom and other utility companies that don’t really get affected badly during a recession but also grow their earnings really well when there is a boom in the economy.

Moderator:
Right.

Gary:
So basically, going back to interest rates, that was one benefit to that. But, there are also other benefits of low interest rates. Corporations have looked into borrowing at low interest rates and, since they have a place where to put that money because the economy is growing slow, they put it back into the stocks via buy backs.

Moderator:
We’ve talked about corporate buy backs.

Gary:
Right, so you could theoretically say that a lot of people have started kind of making the comparison. If you’re looking for appreciation of capital, you’ve typically historically looked at the stock market. If you’re looking for yield, you’ve looked at the bond market right? Very rarely do people make bets on the bond market. They typically buy it, hold it, get paid interest rates, get some print symbol returned after the duration of the bond and they reinvest it to get the yield. Stocks have typically been where you want to look for appreciation. So if you want to buy stocks, typically, it’s because your think the price will go up. You bought Apple because you think it’s a great company and it’ll continue to innovate, earnings will continue to go up, the stock prices will continue to go higher versus getting a dividend from that move, 3% or so. This is exemplified by that most high growth companies, companies with really high stock appreciation, typically don’t pay dividends; Facebook, Google, Amazon etc. All of these companies typically don’t pay dividends because they know that the majority of the people buying their stocks are buying it for appreciation.

So now in the last year or so, you’ve seen a big shift where people are investing in the stock market for yield. That’s why the yield paying names have outperformed; except for that last Trump Rally. Over the last 2 years, utility companies have done really well. Food and stuff like that, which has pretty safe and has a decent yield, has done really well. And, things that you would usually associate with appreciation, outside of the Fang stocks, has done relatively poorly compared to the dividends. On the other hand, people were buying the bond marker not for the yield because it was paying close to 0%, but because they assumed that government would continue to buy and push down yields and there’s going to be appreciation as the yields go lower. So there has been this shift in the last two years of where people invest and for what reasons.

Now, you might be seeing rotation back as how it used to be as the 10 year bond is giving you increased pensions, close to 2.5% versus 1.5% just a few months ago. I think you might see a rotation back, out of defensive names of stocks, into bonds as the price goes up. Hopefully, people will begin looking for appreciation and buying high value stock that are going to continue to grow their EPS.

As interest rate go up, obviously, they also affect housing. Interest rates are such a complex universe.

Moderator:
I don’t know if this is going off topic, but since we also talk about futures, commodities and forex, what about does asset classes?

Gary:
Let’s talk about the discrepancy of interest rates, especially in Europe, which is the largest economic block in the word. You’ve seen interest rates go negative. You’ve seen QE. So obviously, the disparities, as interest rates in the US go up and those in Europe stay low, the dollar will outperform. Interest rates are the main reason for currencies to go up and down. It China, you’ve seen the same thing; as US raises interest rates, the Chinese currency gets stronger because they are pegged to the dollar, which affects their exports to other markets like Europe and other places in Asia. Plus, their manufacturing becomes more expensive. You’ll see them starting to devalue their currency. You’ve seen that is had gone from 6.5 to 7.It’s not something they want; it’s been important to them to have a strong currency, but they have to walk that tight rope of not hurting their economy when having artificially strong currency and also, not allowing it to devalue too fast and people loosing faith in it because then, you have capital outflows.

So interest rates affect everything. We can have a long-term conversation about it. I think we could make a different conversation about where oil prices and currencies are going because interest rates don’t affect oil prices directly, but they do through the fact that they make the dollar stronger. Since the oil price is in dollars, it puts a little bit of pressure on prices. So, we can talk about that in a different podcast because that’s entity to itself. But, going back how interest rates affect assets here, as the rates go lower, they push people looking for yield to the market and as the yields go back up, it’s going to push people rotation out of it.

Moderator:
So do you think we’re at the point now, where increase in interest rates will start pushing people back into the market?

Gary:
I still think it’s relatively low.

Moderator:
Right, we know that, historically, that’s quite low, but as far as for the last eight years, it’s considered quite high considering the amount of debt that these companies have.

Gary:
Yeah, I think that any market trades at an avalanche effect. So when things are good, people just want to buy it. They don’t care about what the prices are and think it’s definitely going to go higher. This is when you have irrational exuberates. Like Greenspan said it in the late 90s, where people don’t care about evaluation; they just see it as the price as the main indication and they want in. This causes prices to go even higher. So it’s like an avalanche, right?

Moderator:
Right.

Gary:
Then, on the way down, you have the same thing; like what happened when housing princes began crashing. People were like, ‘’Oh, well this 800 000$ house, if it falls to 650 000$, I’d be a buyer.’’ But, when it does fall to 650 000$, everybody is talking about how the housing market is crashing and all of a sudden, they’re not so comfortable buying at 650 000$ and they’re looking to buy at 500 000$. Then, it goes down to 500 000$ and feel more comfortable at 400 000$. There’s this constant avalanche effect on both upside and downside, which makes stuff irrational. It’s kind of like a pendulum. The pendulum always over-swings one side or the other way. So housing probably hit too hard in 09. Stock shouldn’t have been so high in 2008. So there’s always this last point of exuberates both to the upside and downside. So, I think if you asked somebody 3 months ago if they’d buy 10 years at 2.5% when the 10 years is trading at 1.5%, they would definitely have said yes. But now that we are here and it’s such a rapid paste, I think people are going to say that it’s definitely going to go to 3-3.5%. So they won’t want to tie up their money for 10 years in something that’s 2.5% when they could get 3.5%.

The problem is that, as yields arise, it’s going to get more expensive to do corporate buy backs, which, in my opinion, has been the main reason why the stock market has gone up. Also, it’s going to cost a lot of money to service the US debt. We have 20 trillion dollars of debt I believe. That gets refinanced. Yes, we’ve pushed out maturity level, longer dates and so on but, every 50 or 100 base points, that adds up. That’s going to put a big bump on national debt. That, I think, is one the main reason why I don’t think the FR is going to allow rates to get out of control on the upside.

Moderator:
So we’ve spoken before about corporate buy backs and on why they’re really one of the fundamental factors that’s pushing prices higher. As we see increased interest rates, do you think this is pretty much moving us towards the slowing down of the market and we’re going to see kind of a plateau happening and possibly a downturn?

Gary:
For now, I see that companies are getting excited. People are really psyched and they really truly believe that Trump administration is going to be pro-business, lower regulation, make stuff easier to be done and answer less to the environmentalists of the world.

Moderator:
And, that may have more of an effect than interest rates?

Gary:
Right. So I think that’s going to be good for the economy. The GDP growth will grow. That’s going to be, in turn, why interest rates go up. As the economy goes better, that the catalyst for interest rates to go up.

Every bull market dies because rates get too high. So, if you keep rates low for a long time, you’ll just create bubbles. Eventually they’ll pop on their own, but it’ll take a really long time for a bubble to pop on its own. So typically, a bubble pop because interest rate get risen to a more normalized level and all of those people who took access leverage get hurt, because they took too much leverage at a time where they shouldn’t have taken leverage.

Keeping interest rates low kills competition and hurts a lot of people. Let me give you an example; Hedge funds now have access to a lot of money and low interest rates. So now, they’re looking for alternative methods to invest their money because the stock market is relatively flat and they want to diversify. So they go into a business, like apartment buying and renting let’s say. Historically, the cap rate on a rental market was 5%. So the person who buys that apartment market in taking concerning risks. He’s willing to take those risks and make 5% because the risks are not very high and it’s a normalized rate. When the economy is bad, there are more defaults, so the prices for the apartment building goes down, rents should be stabilized so now, you’re willing to take 5% because it seems like a risk. Now, you’re willing to take 8% and so on. That’s a normal market.

But, when you’re giving out money to hedge funds at 0% or very low interest rates, they have a small part to go over and make money. So what ends up happening is that they overpaid for those rental assets and they’re willing to make a cap rate of only 2%, because they’re borrowing a ton of money at 1% and are very happy. The small business owner can’t keep up with that because a) they can’t borrow money at the same rate as big hedge funds, but also they’re living off of that money. So they’re not so much concerned about their cap rate, as they are about the amount of money they need to make per year, because they’re a small business and own 3-4 properties. So when you push those cap rate from 5% to 1%, that small business owner can’t play that field, because he doesn’t have enough cash to put into the property to make the amount of money he needs per year. However, eventually, as prices go higher and rents don’t keep up, he’s making less money than he needs to live. So he either has to get leveraged; he has to be able to borrow money from the bank at a low enough rate for it to make sense, or he has to find himself a new business. And, typically, banks haven’t really been happy to lend to the average little guy. So if you’ve had the property before and seen your asset price go up, you’re happy. But, for the new guy who’s getting involved in this business, it’s really impossible because they’re not making enough for it to make sense.

So the big hedge funds are going it just because they’re just looking to make the disparity of what they’re borrowing for, which is let’s say 1% and the cap rate, which is 2%. They’re happy to make 1% on a hundred million dollars. But, the little guy, who has one million dollars and he tries to buy a 2-3 family apartment building, has been squeezed out, which is obviously bad for competition.

Moderator:
Gary, thank you so much for your time. Again, SizeTraders, feel free to sign up for the podcasts and subscribe. We’ll be back again Gary

Gary:
Thanks a lot.

Moderator:
Take care.

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