The importance of interest rates and the Fed

Discussions about interest rates and the US Federal Reserve account for a disproportionate amount of financial news.

This is because the Fed indirectly influences global interest rates – and interest rates affect all asset prices and currencies, and thus our investment returns.

But how, and why? The easiest way to understand is by example.

If you put R100 into a one-year investment (let’s call it a ‘bond’) that earns a fixed 25% interest per annum, it is easy to see that in a year’s time your R100 would be worth R125.

Put another way, at this 25% interest rate, R125 of capital in a year’s time is worth R100 of today’s money.

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Now say the authority that decides what the interest rate is – let’s call them central banks – changes the interest rate (for new bonds) to 20% per annum moments after you have invested your R100 into the bond. Your bond still earns 25% per annum since it was fixed at the previous interest rate and not the new 20% rate.

All new bonds of R100 will however only be worth R120 in a year’s time.

Yet your bond will still pay out R125 in a year’s time, and is thus now more valuable than it was a moment ago. Yay!

So, at 20% per annum interest rate, how much will R125 be worth in a year’s time? Well, it will be worth the same amount as whatever we would need to invest today to get paid out R125 in a year’s time. Simple maths can work this out, as follows: (R125 x 120)/100 = R104.17.

Let’s logic-check this: With a 20% per annum interest rate, if I invest R104.17 for a year it will be worth R125 in a year’s time (=R104.17 x [1+25%]).

What does this reveal about interest rates?

This example shows us that by changing the interest rate, the central bank has changed the value of your investment. Since financial markets are filled with investments that have expected future cash flows, the central bank changing the interest rate changes the value of all investments.

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While a fixed-rate bond is simple to understand, businesses also have expected future cash flows. These are uncertain and more volatile than fixed-rate bonds, but the future cash flows (or the market’s expectation of them) is quite real.

Thus, changing the interest rate changes the value of these future cash flows from businesses – and since shares on global stock markets are fractional ownership in these businesses, it will affect the share prices of all companies.

Therefore, central banks affect interest rates and interest rates affect debt and equity markets.

How does the Fed fit in?

Countries don’t exist in isolation and capital flows across (most) borders via currency.

If I am a global investor and can invest my capital into a ‘Country A’ to get a 10% return or ‘Country B’ to get a 15% return – all else being equal – I will take my capital, sell the currency of Country A (weakening it), buy the currency of Country B (strengthening it) and invest it in Country B to earn a 15% return.

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I might be a small investor, but multiply this transaction by the millions of market participants out there and the vast sums of capital the global market contains …

Thus, interest rates also affect currencies.

More subtly, the difference between countries’ interest rates affects currencies.

And if this difference is too large, then the low-interest-rate country’s currency will weaken significantly (lifting its imported inflation rate and demanding a higher interest rate) and the high-interest-rate country’s currency will strengthen significantly (perhaps even pushing its inflation into deflation, demanding interest rate cuts to stimulate the economy).

The global reserve currency

Enter the US dollar. Following World War II and the Bretton Woods Agreement of 1944, the dollar was pegged to gold, and most other currencies were pegged to the dollar.

While the gold peg has fallen away, the dollar is still the global reserve currency – used for international trade (and apparently the stuffing of presidents’ couches) and central bank reserves, and almost all commodities everywhere are quoted in dollars.

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It is in this way – with the dollar as the global reserve currency and the US central bank (the Fed) deciding the interest rate that dollars can earn – that this central bank indirectly dictates the direction, rate of change, and ultimate level of global interest rates.

(Assuming that other central banks in countries whose currencies are not the dollar do not want their currencies to blow out against the dollar; looking at you, Turkey …).

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At this point, the logical question is: what motivates the Fed to change the interest rate?

The market spends a lot of time trying to work this out. Unfortunately, we’ve run out of space to address that but it is worth reading through the Fed’s structure and purpose in its own words here: Structure of the Federal Reserve System.

In closing, the Fed dictates the dollar’s interest rate, which dominates other central banks’ domestic interest rates that ultimately feed into financial market asset prices and, thus, our investments’ returns.

As usual, the real world is more nuanced and complicated, but this article should help you better grasp why interest rates and the Fed dominate many financial market discussions.

* Keith McLachlan is investment officer at Integral Asset Management.