With the Federal Reserve is expected to hike interest rates again this week to roughly 2.25 percent, I've decided I'd like to write a few articles on how interest rates affect your investments.
Fed policy is still seen as slightly accommodative to neutral as interest rates trail the roughly 2.7 percent rate of inflation the U.S. economy is experiencing currently. However, rising interest rates have real effects on the economy, household budgets, and the stock market.
Below is the Federal Reserve dot plot (shows where Fed intends to take interest rates, each dot is a vote). More on the dot plot here.
American consumers don't seem to pay a lot of attention to the Federal Reserve, at least compared to Wall Street. Maybe they should. Here is a graph published in USA Today of how much American households owe. (Not every household has every kind of debt, so the average debt per household is roughly $150,000)
Note that not everyone has every kind of debt, and it can take a while for rising interest rates to trickle through. In the long run, all else being equal, every 1 percent that interest rates go up vacuums about $1500 per year from the typical household. Student loans especially are going to be a drag on consumers. These are tied to the Fed rates so next year they'll reset about 1-1.5 percent higher than this year. Here's what they've done over the last few years. Corporations rely on credit also, and higher interest rates tend to reduce investment in new projects. This pulls the reins on the macro level growth in the economy.
This is a back-of-the-envelope calculation, but I estimate that all else being equal, every 1 percent rise in interest rates reduces consumers' income by 2.5-3 percent and takes 4-5 percent off stock prices.
Some sectors are affected more, like the housing market. Since most homebuyers rely on mortgages, rising interest rates crush their ability to purchase homes. On the other hand, some sectors benefit, like the financial sector. I would like to do a follow-up article on sector breakdowns with earnings because sometimes the picture is more complicated around rising rates than it seems at first, especially for REITs and financial companies. That said, companies that tend to have net interest income greater than interest expense tend to do well at this point in the cycle. For example, higher mortgage rates suck more money out of consumers' pockets, but the banks who issue them are making more and more money.
Economists like to talk about the "risk-free rate" when evaluating investments. It's mostly theoretical, but it has an impact on you.
Your household risk-free rate is equal to the debt you have with the highest interest rate.
For example, let's say you work in tech and are vested a $200,000 bonus after tax. You have the choice to either pay down debt or invest the money. If you have a $20,000 balance on your credit card at 14 percent, you should pay that off before investing a dime, because by paying it off you improve your cash flow by $20,000 X 14 percent, or $2800 per year. You don't have to take any risk to do this and it has the same effect on your cash flow as an investment paying 14 percent. This example is a little exaggerated for effect, but student loan rates for new loans are above 5 percent and will be sitting close to 6 percent as interest rates rise. Mortgages too are pushing 5 percent and headed to 6 within 12 months if the Fed keeps its course. Most affluent households carry at least one of these types of debt. Therefore, the risk-free rate for the typical moderately affluent household is 5-6 percent. This is one of the reasons I believe that interest rates affect stock valuations more quickly than consumer incomes and shrinks P/E ratios of stocks. This is because rational people will invest in bonds or pay off debt rather than risk money in the market if the returns are close to equal.
If you aren't super bullish on the markets, this is a nice way to keep making progress towards your financial goals and lock in returns free of risk. Now, of course, you can make the argument that you could invest the money in stocks and pay off the debt later while keeping liquidity.
I'm fine with this argument in principle. However, there seems to be an epidemic of fairly young and affluent people paying interest on mortgage debt and student loans while keeping 40+ percent of their portfolio in cash and bonds. This is completely irrational. By having a large bond and cash allocation on the short end of the yield curve, and borrowing on the long end of the yield curve, you are basically the opposite of a bank. Instead of borrowing cheap and lending expensive, you are borrowing expensive and lending cheap. Since you are less creditworthy than the people you are lending to, you realize a large and negative arbitrage from your personal balance sheet. In plain English, if you are doing this, you are giving your money away.
Don't do irrational stuff! Instead, if you are in the position of our hypothetical household with a nice bonus, either pay off your debt or invest in something that carries a higher return than your debt. You obviously want to keep 3-6 months cash reserves for liquidity, but if you're worried about liquidity and pumping money into your house, simply write the check and go get a HELOC the next day. It'll cost you a few hundred bucks max to set up and you can tap the liquidity whenever you need. The bank could theoretically suspend your line of credit if home prices fall and the economy goes south but you could almost certainly write yourself a check for the maximum amount allowed long before the bank's risk management team decides to cut off everyone's credit.
Bottom line: If you wouldn't take out a margin loan to buy bonds, you probably shouldn't be doing it with a big mortgage outstanding either. Your balance sheet looks the nearly the same in both cases, the only difference is the payment terms. Instead, pay off your own debt and get a line of credit for flexibility.
1. I was wrong about Micron (MU) shooting up after earnings but as of the time of writing this, the stock is up roughly 2-3 percent since my recommendation last week. I personally would look to switch to common stock here. The risk/reward has shifted so I now prefer the common stock. Depending on where you bought, you may be able to sell the January 40s for as much as you paid. It's up to you if you bought. If you want to stay in the trade, know that the original catalyst of an earnings surprise is no longer in place. However, the stock is still capable of rising on the buyback. I advise caution and patience on Micron but wish everyone the best of luck!
2. Tilray (TLRY) is an interesting case study of short squeezes and retail investor behavior not having the mathematical framework for understanding either short squeezes or dumb money.
I actually called the top in Tilray to the exact penny this week. I did this partially because I was lucky and partially because I was able to exploit a behavior bias that retail investors (and to a lesser extent, institutional investors) have and made an educated guess for where the stock would top out.
Market participants have a strong tendency to put limit orders in at round numbers. For example, if a stock is trading for $99.50, you can bet that when you look at the order book there will be a lot of offers to sell for $100. In Tilray's case, a lot of people simultaneously decided they would sell at $300, and most of them did not get their orders filled. Some of them probably still own it. The human mind likes to gravitate to round numbers. This bias is exacerbated by investors calling in orders over the phone, where they might say something like "Let's sell Tilray for $300," but are much less likely to say $299.95, for example.
Some of my buddies were long Tilray and were looking for a sale price. I actually had them put in an order to sell at $299.99. Both their orders were filled in their entirety. The point of this is that there are resistance and support around round numbers, and it's significantly easier to get filled a few cents below a round number than a few cents above it. This is explained not by random chance but by understanding game theory and bias. Picking less popular exit and entry points and using the dumb money in the order book as support rather than fighting against it as resistance helps you win a little more often. It's a small edge, but an edge nonetheless.
3. The Visa trade is up between 25 and 80 percent, depending on when you bought. The AAPL trade is looking great and is up over 150 percent. The ITB sell continues to be proved right, and UNP and BA have hit new all-time highs since my calls.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.