Interest rates and the Fed: How does it all work?

Phil: These are not one for one. It does not mean the Fed cuts a quarter point, let's say, and mortgage rates all shift lower by a quarter point. Mortgage rates, longer-term rates, they're their own market. Do they rhyme sometimes with the Fed? Yes. But they do operate independently. Chairman Greenspan referred to this as the great conundrum—that the Fed controls the overnight rate, not longer-term rates.

Thomas: I'm Thomas O'Keefe.

Phil: I'm Phil Neuhart.

Thomas: And today, we're going to be discussing interest rates. Specifically, the Federal Reserve has lowered rates. What do we need to think about as it pertains to portfolio construction and how we invest money and how we think about building portfolios?

So, Phil, what is the fed funds rate?

Phil: It really is just the rate banks charge to lend excess reserves to each other overnight. The important part there is overnight. So what does this rate really drive? It drives short-term interest rates in our economy. It doesn't necessarily drive longer-term rates. We'll talk about that more in a moment.

Short-term lending, short-term rates is what it drives. It is set by the Federal Open Market Committee. That's part of the Federal Reserve. They meet eight times scheduled a year. Now, they can have an emergency meeting if something's happening in the economy, but that's where they make their rate decisions. And in these rate decisions, there's a statement. The Chair, currently Chair Powell, has a press conference.

And then four times a year, quarterly, they release with this announcement the Summary of Economic Projections, which has projections from the committee on everything from growth to unemployment to the future path of interest rates.

Thomas: So you and I do not have access to this rate. Is that correct?

Phil: That's right. We have access to things that are very correlated with this rate, right? Anyone who has a money market knows that when the Fed cuts, their money market rate changes, or when the Fed hikes, same thing. But directly, this is actually lending between banks.

Thomas: And so this is really, really short term in duration. Can you talk a little bit about the yield curve and how we think about short duration versus, say, intermediate versus long?

Phil: Yeah, so you hear the yield curve referred to. All it is, if you imagine, is a vertical axis—a y axis that's yields on Treasuries—and an x-axis or horizontal axis that goes from 1 month all the way out to 30-year. Short-term rates to long-term rates.

That yield curve, if you imagine, is generally upward sloping. All that means is that shorter-term rates are lower than longer-term rates. And why is that? Investors demand more yield to lend for a longer period of time.

Thomas: This is a risk thing, right?

Phil: Yeah, it's just risk. There's interest rate risk. With sovereigns, hopefully there's no credit risk. But with a corporation, there's, of course, credit risk. The longer you're lending the money, the higher risk it is. So generally, short-term rates are below long-term rates. Currently, the yield curve—very short-term rates—are a little bit elevated by the fed funds rate. Then the yield curve dips and then it goes higher as you look further out.

A few years ago, we had what's called an inverted yield curve, right? That's often viewed as a predictor of recession. It didn't work a couple of years ago, but that is when short-term rates are above long-term rates. That's viewed as a distortion. Doesn't necessarily make sense. But I think the real takeaway with the yield curve is just because the Fed is hiking or cutting does not mean longer-term rates. The 10-year Treasury or mortgage rates, for example, are going to move in tandem.

Thomas: So if I'm looking at a yield curve right now, and the Fed decided to cut interest rates, I should expect to see the shortest rate on there decline, correct?

Phil: That's right. And sometimes that has already priced in before the Fed even makes the decision. But yes, for example, last year, the Fed cut four times, right? Actually, they cut three times by a total of 1%. And what did the 10-year Treasury yield do? It rose—even as the Fed was lowering short-term rates.

So these are not one for one. It does not mean the Fed cuts a quarter point, let's say, and mortgage rates all shift lower by a quarter point. Mortgage rates, longer-term rates—they're their own market. Do they rhyme sometimes with the Fed? Yes. But they do operate independently. Chairman Greenspan referred to this as the great conundrum—that the Fed controls the overnight rate, not longer-term rates.

Thomas: So the market is really in control of the long term. That's more prospects for growth. That's the market understanding.

Phil: Inflation expectations, capital flows across different sovereign nations. I mean, there's so much that goes into that. So we've talked a little bit about what the federal funds rate is. Let's talk a little bit more about the investing side of things. Let's talk about fixed income, or bonds, to begin with. What do interest rates mean for the price of fixed income and for fixed income investors?

Thomas: So if we start with bonds, really, the one thing you need to know is bonds have an inverse relationship to interest rates. So if interest rates go down, the price of a bond will go up. If interest rates go up, the price of the bond will go down. So if you're holding a specific bond—and this, I should say, this is all very general, right? It really kind of depends on the bond that you're holding.

But for most bonds that you're going to hold in a particular diversified portfolio, you should understand that inverse relationship. So as rates tick down, you should expect the price of that bond to go up. Now this is also really dependent on—you talked about yield curve—it depends on the maturity of that bond.

So if we have a bond that's maturing in the next 3 months, the sensitivity to those interest rate increases or decreases is very low. So you're not going to expect a large shift in that price. But as that bond's maturity is longer or further out into the future, changes in that interest rate are actually going to change the price of that bond more.

Phil: That's right. It's more sensitive. It's called duration risk, but of course the further you go out, the more sensitive you are to variables changing.

Thomas: That's absolutely right. So we'll see that in portfolios. As these interest rates are changing, we will actually see those prices of those bonds shift.

Phil: So what about equity markets or the stock market? How do you think about changes in interest rates and yields relative to these more risk-on asset classes?

Thomas: Yeah, there's three main points that we look at in terms of equity sensitivity to interest rates. I would say there's opportunity cost, there's cost of capital and there's discount rate. So if we start with opportunity cost, really this is quite simple. It's an investor looking to put capital to work. You're looking for the best risk-reward trade-off that you can find.

So if interest rates are at zero, you need to find a place for your money that is going to yield you more than zero. So it's going to push you out into something more risky, maybe equities. The higher interest rates are, the more you would prefer to take that return because there is less risk on that than, say, a riskier asset like equities.

Phil: That's right. It drives capital flows into something like fixed income in that scenario because expected returns are just more attractive.

Thomas: That's absolutely right. So the first impact that we see as interest rates decline, we would expect that there's some decision that investors need to make in terms of where they're going to invest their capital, and maybe now with lower rates, we might expect that they would prefer riskier assets that have a higher return.

Phil: Yeah, it really depends on their return requirements, but absolutely.

Thomas: That's absolutely right. So then the second one is really cost of capital, and you can look at this in a couple different ways. Number one is just the burden of servicing debt for companies. So if you think about the capitalization structure of these companies, they have a decision of equity or debt on their balance sheet.

So if they are holding debt and the interest rate goes down, then servicing that debt—or the interest expense that they have on that debt—will lessen. And so that hopefully hits the bottom line and hopefully becomes something that props up that equity valuation. They're worth more because they have less interest expense.

The other way to think about it really is the cost of capital to take on new projects. So if you think about a company that wants to, say, buy a building, buy another company, invest in a new technology, hire more people—that'll cost money. You may have it on your balance sheet, or you may need to actually borrow money in order to actually execute on that project.

Phil: That's right.

Thomas: So if that is lower, the cost of financing is lower for that company, then you're more likely to engage in that project, buy that building, buy that company.

Phil: That has implications for future growth of that company and really for the economy broadly. Think about something like capital expenditures. If rates are lower, well, the hurdle to enter into that project should be lower as well. What about the final prong here, discount rate?

Thomas: Yeah, so if you think about an investor looking to value a company, what you're really doing is you're looking at future cash flows. That can be dividends. It can be retained earnings. And what you're looking to do is you're looking to say, "These cash flows that we're expecting into the future, we need to actually look at the present value of these cash flows." And so in order to look at, say, a cash flow or a dividend that's going to be paid a year from now, you need to actually be able to say, "What is that worth today?" Because those are in tomorrow dollars.

So we need to know what are they in today dollars. And so you have to actually divide them by the interest rate. And so usually you use a risk-free rate, which for many years was zero—or very close to zero. And so in that environment, the lower your denominator is, the higher your present value for that company is going.

Phil: Because those future cash flows are worth more.

Thomas: That's exactly right. And so what you're going to end up doing—if you're an investor and you have to make a decision on buying or not buying a particular security—if that present value is higher, you're going to be more likely to buy it at its present value.

Phil: That's right. So if we think about the real world, if you have a segment of the economy like the innovation economy, very young companies where all of the cash flows are really in the future, maybe years into the future, interest rates going up really can hurt the valuation of those companies.

Thomas: Yeah, that's absolutely right. It's just a multiplier effect on the whole thing.

Phil: That's right. So lower rates just make things worth more and can really help the broader economy. So let's turn to the portfolio now. What do rates moving around mean for just your average investor, for our clients?

Thomas: Yeah, I think there's three things to think about here from a broader portfolio perspective. I'd say the first is really the data that we look at. We are looking at data constantly as we're trying to put together our capital market assumptions. So these are our forward-looking expectations for what returns are going look like for different asset classes—so different equities, different fixed income asset classes.

And so interest rates are a key component to that. So as we see these interest rates moving, in this case moving down, it is one of the data points or one of the factors that we are looking at that actually impact our future expected returns. Now, there's other factors in there that are very correlated or related to interest rates—say inflation, employment data, growth metrics, valuations, all of these different data points—which have some relative exposure to interest rates, as well as the actual interest rate absolute and relative change numbers, are all being fed into our models in order to understand what those expected returns are going to look like.

So that's one way that changing interest rates impacts our portfolio construction. I'd say the second is more of a client risk-return decision.

Phil: Client-specific.

Thomas: That's right. So this is less a decision on optimizing a portfolio based on data, but it's optimizing it based off of a client-specific situation and their particular risk profile. And this comes back to opportunity costs, where a particular client may look at the environment—and let's say interest rates are going down—and may think, "Well, I actually need a higher return." Say you're an institution that has a hurdle rate that you're trying to hit, and now with lower interest rates, fixed income may not get there for you. And so you might have to make a bigger, high-level allocation decision on shifting away from risk-managing assets and towards return-generating assets.

Phil: Right, and we saw the inverse happen when rates rose so rapidly in recent years, is institutions that had a required rate of return, the truth is that they were really accessing equity and other return-generating assets. Well, suddenly if risk-managing assets have a higher interest rate, that can be more attractive. Now we want to be clear. This is client-specific. This is why financial planning matters. This is why—if you're an institution—thinking about your required rate of return matters. But suddenly, these asset classes like fixed income, they can be worth a lot more if yield is higher to your expected rate of return.

Thomas: Yeah, think about how hard it was in this zero-interest-rate environment for most investors who didn't have a really high risk tolerance. You are now being forced to go out riskier and riskier in terms of your allocation just to get a return that is sufficient to meet whatever your needs are, whether you're an institution that has a specific return target or whether you're an individual who's just looking to generate a predictable return year over year.

The third point really is cash management, right? You talked a little bit about the fed funds rate, the short end of the curve, how that can impact money market funds, maybe your checking and savings accounts are shifting, because that's really the shortest rate you can really access.

And so we look at the trade-off or the decision that needs to be made in terms of how you think about cash management. Cash management is a complicated and very personal topic for clients. You need cash for many things. You need it to pay your groceries, you need it to pay your rent, you need it to pay your mortgage, your kids' school. You may also have some of it as dry powder. And this dry powder really is not earmarked for anything except for opportunities.

And so what we start to look at then is your dry powder is earning a certain return, and maybe that return now is no longer valuable to you. And you now need to start exploring, "Should I go longer on the yield curve?" like we were discussing earlier. That's taking on more risk for potentially more return in a normal yield-curve environment.

Or you could even take the jump to equities, and you could say, "Well, that cash that I had at 4% is not yielding 4% anymore. It's yielding 3.5% or it's yielding lower than that. Maybe I need to shift that to a completely different security or a completely different asset class."

So I think those three things, you know, really the data that informs our asset class and allocation decisions, the potential client shifting of allocation based off of their risk preference and then finally how we think about cash and whether to hold it really short duration, whether to go further or whether to actually take on more risk.

Phil: Yeah, I think all of the items we've touched on today really highlight why market participants are so focused on the Fed and other rates as well—10-year Treasury, for example. It's just so important to the economy and to investment returns in so many ways. It really is a critical component.

Thomas: Yeah, and this is just one specific component overall. There's many different components that impact the decisions that you're going to be making as an investor.

And really, we here can and will walk you through all those different decision-making sort of factors that you have. So hopefully this is an interesting topic, really timely and topical to what's going on out in the markets, what the Fed is doing—and hopefully gives people a perspective of how to think about rates specifically for their particular portfolios as you're seeing it in the headlines.

So thank you for joining us today. Phil, thank you for being here. Thank you everyone for listening. We are excited to have you back soon.

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