I have often said in the past that if you can understand interest rates, then you can understand just about anything going on in the economy with regard to a macro-scale. In today’s world, this couldn’t be more true. Let’s take a look.
Mr. Smith wants to buy a house. He has $250,000 for a down payment, and he has a steady job that allows for him to make a $5,300 monthly payment (what a great job!). He wants to stretch his budget as much as possible, and he finds that he can purchase a $1,250,000 home. He will put his $250,000 down for the down payment, and he plans to get a $1,000,000 loan from the bank at an interest rate of 5.0% for a 30-year term.
He buys the house! Congratulations Mr. Smith! Now… Mr. Smith has to begin paying back his loan on a monthly basis. At 5.0% interest, his monthly cost is roughly $5368 per month over the next 30 years (really stretched that budget!). When he makes his last payment in 30 years, he will have paid a total of $2,182,557 roughly. That includes the $1,000,000 in principle, $250,000 in down payment, and he would have paid $932,557 in interest roughly.
Now… what would have happened if interest rates were 2.0%? Mr. Smith still wants to stretch his budget as far as he can to spend his roughly $5300 per month, and he still has a down payment set aside of $250,000. He finds a home that is listed for $1,700,000. Can he afford it? Well, he goes to the bank, and they tell him that with interest rates at 2.0%, his down payment of $250,000, and monthly payment allotment of $5300 (and excellent credit score of course), he can afford this $1.70 million home. He immediately enters a loan agreement for a loan amount of $1,450,000.
After purchasing the home, he begins to make his monthly payments of roughly $5359 (Mr. Smith knows how to stretch a good budget). 30 years go by… after paying his last house payment, Mr. Smith has paid a total of $2,179,413. That includes the initial loan amount of $1,450,000, the down payment of $250,000, and he will have paid $479,413 in interest roughly.
As you can see, the lower interest rate actually allowed Mr. Smith to afford a more expensive house because the cost of borrowing money was much much less. In the first scenario, it cost him $932,557 in interest to obtain a $1,000,000 loan. In the second scenario with lower interest rates, Mr. Smith had a much larger loan, $1,450,000, but it only cost him $479,413. In short, the price of money had gone down, so he could afford to borrow more. This is how low interest rates drive asset prices higher… if people can spend more, they usually do. This helps explain why the housing market has become so hot in many areas of the country. However, even the housing market has a top to it. Low interest rates may drive asset prices higher; however, after asset prices reach a point high enough, the benefit of low interest rates has been lost. (Likewise, when rates rise, asset prices come down… usually very quickly!)
Now… does this explain why the stock market is at an all time high? The answer is a resounding yes. However, unlike the housing market, the stock market is actually much scarier. Why is that? Well, in short, it is because the money being borrowed that is going into the stock market often times is being borrowed at a 0.0% interest rate. What does this mean for the stock market?
First of all, why are interest rates so low? When the federal reserve monetizes the country’s debt, it is buying issued bonds that releases hordes of cash into the economy. That cash makes its way into the economy via big banks most of the time, and it also serves to drive interest rates on bonds way down artifically. A large portion of this cash also finds its way into the stock market via investment bankers and other avenues. What if an investor wants to borrow $1,000,000 and put it into a blue-chip dividend stock with a yield of 4.0%? With the low risk, the investor is netting 4.0% plus any capital gains due to the zero percent interest rate on the borrowed money. Couldn’t this investor lose money via capital gains loss on the stock? Well, he could, theoretically… but he or she won’t. Let me explain.
With zero percent interest rates on money, everyone is going to have this idea. This means that it is virtually impossible to lose money on an index in equities. For example, borrow $1 million, borrow $10 million, or even borrow $100 million, and put it all in the SP500 index. You won’t lose money because everyone in the world is taking free money (remember… 0% percent interest) and shoveling it into the stock market. This massive avalanche of buying will drive up stock market prices so high that it will seem unbelievable. It has to stop right? Well… here’s the scary thing… unlike the housing market in which interest rates are never truly 0.0%, investment loans are just that… 0.0%. Inflated asset prices never get more expensive to invest in. Investors cost of borrowing is always $0. Investors are free to continue shoveling money into equities at no cost to themselves.
What about the risk? Why don’t investors put the money in something with less risk? The simple answer is that free money crushes the yield on just about every asset in existence. A simple proof can be seen in savings accounts and CD rates, both of which have been rock bottom since 2009 when the Federal Reserve began their zero-interest rate policy. Investors must put it into the stock market to chase any small yield they can. This is known as TINA (there is no alternative) investing, and it has been highly successful for more than a decade.
Okay, the SP500 has gone from 666 to over 4200 as of this writing, and this happened over the course of 12+ years. It has to be a bubble right? Correct. It is a massive bubble. However, with zero-percent interest rates, this bubble has no theoretical upper-limit. Don’t think the SP500 can reach 5,000? Wrong, it could be at 10,000 by the time this is all over. The Federal Reserve along with fiscal stimulus from congress equates to truckloads of money being dumped into the stock market. It’s a steamroller, and you do not want to be caught in front of it.
What could stop it? In my mind, there are several things that could stop it. Failure of confidence in the dollar, massive inflation or deflation, et cetera. However, I can guarantee that the single most powerful thing that could stop it, is a rise in interest rates whether it be by the Federal Reserve or bond vigilantes. This would effectively cause the world’s biggest margin call in history. You think the flash crash of the early 2010’s was bad? You think the knee jerk sell off for a couple months when Covid first hit was bad? Those are nothing. An earnest rise in interest rates would cause a panic like no other in the stock market.
It would be like a parent coming into a teenager’s room and saying, “Hey, you can only live here if you start to pay $1,000 in rent.” Well, the teenager wasn’t expecting this. He/she has no job. They can’t afford the rent. They have no option but to get kicked out. Same with investors. They can’t afford massive amounts of money anymore if interest rates trend up meaningfully. They are forced to sell. Just like you couldn’t lose on the way up, you won’t be able to win on the way down.
The scariest thing about all of this of course is that no one believes it can happen. If a money manager graduated from college in 2009, they have gone their whole career without ever seeing a bear market. They don’t even know what one would look like. But I can guarantee their first one will leave them scarred. Imagine the SP500 going from 6,000 to 1,500. A drop of 75% seems absurd, but there is historical precedent for it. Trust me, I have heard all of the reason why it cannot happen. And I agree, that in today’s market environment, it cannot happen. However, keep a close eye on the important metrics that make up a market environment. Once they begin to fall, one by one, I have a suspicion that the next bear market will be bigger than the last two. The spring has certainly been pulled back farther than the last two bubbles in recent history.
I have a great deal to gain from a continued bull market; however, the historian in me is hoping for a once in a lifetime, a true six-sigma, gut-wrenching bear market in the next year or ten years. Anyone can make money in bull markets. I have always enjoyed the challenge of making money in a bear market!