October Y2K
Understanding Interest Rates
By
Robert K. Heady
One of the most important aspects of a market economy is interest rates. Interest rates represent the cost of borrowing in a given economy; the higher the rates the more it costs to borrow money.
The most watched interest rate is the Federal Funds Overnight Rate, which is the rate the Federal Reserve charges member banks for overnight loans, presently at 6.5 percent. This is the foundation rate because banks must add to it in order to lend money to consumers in a profitable way; banks borrow at the 6.5 percent rate and charge anywhere from 8 percent to 15 percent and sometimes more. It is the rate the Federal Reserve raises or lowers to have a desired effect on the economy because all interest rates are “pegged” to this particular rate from auto to home equity to margin loans on brokerage accounts.
When the Fed raises rates, the cost of acquiring capital (money) becomes more expensive and this in turn “tightens” money and slows down spending and the overall activity of the marketplace. The lowering of interest rates makes the cost of borrowing cheaper or “loosens money.” If money becomes cheaper to obtain, more consumers will take out loans for acquisitions of all types, including stock purchases.
Why would anyone want to slow down the economy? When money is cheaper to borrow, more circulates in the economy and this in itself tends to drive prices up; consumers are willing and are able to spend a little more for the same goods, historically from 2 percent to 4 percent more per year. Such a period of prosperity is called a period of economic expansion. During lean times or recession, rates are lowered to spark activity by providing more money in the economy.
The money eventually finds its way into the capital markets and begins to bid up the prices of stock shares (equity). Raising interest rates, therefore, is a way of slowing down or dampening the buying power or putting the brakes on. Raising interest rates is necessary during a time of rapid expansion when inflation threatens to overtake the economy and cause a recession. Raising or lowering the interest rate controls the ever-crucial supply of money at the right time.
The debate still rages on, however, whether such action by a central market player, the Fed, is helpful or harmful. Presently, the Federal Reserve bank’s bias is upward—it intends to continue to raise rates throughout the summer.
How does a climate of rising interest rates affect stock prices and what is a good investment class to look towards in such a climate? Remember that the market takes money away from impatient people and gives it to patient people. The long-term investor usually wins over the short-term investor.
In the short term, stock prices usually come down but a wise investor sees an opportunity to buy; this is the right time for buying shares in quality, proven companies. When the rates stabilize, the prices go up again. Long-term bonds and utility stocks will fall if short-term interest rates rise. An interesting investment is the increasingly popular ”floating-rate trusts” which purchase a pool of loans called debt securities from different institutions.
As interest rates rise, the yield on floating-rate trusts usually rises because the rate is variable and tied to a money-market index such as Treasury bills, which usually rise along with short-term rates. The trusts provide diversity to any stock portfolios and smooth out the performance of equities during hard times.
In the marketplace, it is very important to maintain a buy-and-hold philosophy in times of market volatility. It should be remembered that it is only a loss if one accepts a lower price for one’s securities. It is wise to weather the storm and wait.
The Nasdaq, which is heavily weighted on technology stocks, was only 1,600 points three years ago but now it is more than double that value at around 3,400. When it dips to 3,000, buy more of whatever you are holding to lower the average cost of the dollar per share of your investment.
The proper way of investing, therefore, is by building up higher positions over time in quality companies with proven business models. Have no fear for the trend is your friend and time is on your side.
Wakeen Edmonds is a financial executive based in Washington, DC. He can be reached at (202) 262-0612 or by e-mail at WakeenEdmonds@aol.com.
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