Interest rates have been dropping since 1981, when the three month Treasury bill was at 17%. Today, it is near zero. Is there any danger hiding behind these very low current rates?
It does not really matter where they are now. The key is to predict where they are likely to go and to understand the consequences of these movements. Let me explain why predicting the movement of rates is so important.
What Gives Value to an Asset?
Most assets, like bonds, stocks and real estate, derive their value from two fundamental sources: the future income they are expected to pay and the interest rate the market uses to discount those future cash flows. Let’s illustrate with a simple example. Assume one of my daughters is getting married, and I need lots of cash to pay for her wedding. Continue to assume that I own an oil well that generates a net cash flow of $10,000 per year, and I expect it to continue generating that money for years and years to come. But, because I need a large amount of cash now, I have decided to sell it.
How much will someone pay for my oil well? The math is simple: you take the net cash flow and divide it by the prevailing interest rate. Assuming it is 5% now, I should be able to sell the oil well for $200,000. That is the $10,000 annual cash flow divided by 5%. My daughter will have a great wedding!
Let’s fast forward two years from now. Let’s assume that the person who bought my oil well going through a divorce and needs to sell it. How much will he get for it?
Let’s do the math again. Divide the expected annual cash flow of $10,000 by the prevailing interest rate. However, suppose now that interest rates have been rising for the past two years, and they are now 7% instead of the old 5%. How does this affect the selling price of the oil well? If you divide the cash flow by 7%, you get $142,857. That is, not only is my buyer’s life falling apart because of the divorce, he just found out that his cherished oil well is turning out to be a bad investment. He bought it for $200,000, and it is now worth $142,857. He lost $57,143 or 29% of his original investment. Why did this occur? The well is still pumping oil to yield an annual profit of $10,000 so how you can explain the drop in its selling price. Interest rates rose.
What Affect Will Rising Interest Rates Have on Asset Prices?
When interest rates begin rising in the US, and you and I know that it’s only a matter of time, asset prices will likely see a tremendous drop. The culprit? The Federal Reserve. In keeping interest rates so low for this long, they have created a new bubble: asset prices supported by unsustainably low interest rates.
Is the Fed’s policy so bad after all? It depends on whether their actions are benefiting you or harming you. In my particular case, I am a great beneficiary of their actions. To illustrate, I have about one million dollars in debt. A few years ago I was paying 7% for this money, but now I only pay 4%. Whereas then I was paying $70,000 in interest, now I find myself paying only $40,000. I have improved my cash flow by $30,000 each year due to the Fed’s action. Hurrah to the Fed.
While I gained, who lost? Take the case of a retiree who had the same million dollars, but in the bank instead of in debt. He was getting around 4% a few years ago, which means he was receiving $40,000 a year in income. Now the bank is paying him one percent, so his income from the million dollars has dropped to $10,000 per year. He happens to be losing the same $30,000 that I am gaining. He’s hates the Fed!!
What Will Happen When Interest Rates Start Rising?
Regardless of who are the current winners and the losers in this game of keeping interest rates artificially low, we can all feel confident that interest rates will soon rise significantly. After all, just as Christmas comes around only once a year, interest rates this low are a once in a lifetime situation. What happens when interest rates begin to rise? Asset prices will fall. Are you prepared for this transition?
If you want to meet with me to review your personal finances, just reply to this email or call me directly at 714.771.6000