How Higher Interest Rates Alter Our Financial Blueprint
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Look at the money for the rest of us. This is a personal financial on money, how IT works, how to invest in and how to live without worrying about IT. I'm your host, David time.

Today is episode four fifty. It's title. How higher interest rates alter our financial blueprint. Yesterday, the ten year treasury bond yids hit four point seven percent, its highest levels since two thousand seven. The thirty year treasury bon yield was four point eight percent, the highest since twenty ten. The real yield, as reflected in ten year treasury inflation protected securities, is two point three percent.

The difference between the four point seven percent nominal yield for tenure treasury's and the two point three percent real yield is the bond markets consensus for average annual inflation over the next decade. The four point seven percent nominal yield minus the two point three percent real yield equals expected inflation of two point four percent higher interest rates when driven by higher real yields rather than by higher expected inflation. That's good news for us as investors and savers IT means we can earn positive, nearly risk free returns greater than inflation for barriers.

However, higher interest rates are more of a burden. In this episode, we're going to consider six impacts of higher interest rates. We discussed what was driving higher interest rates two weeks ago in episode four forty eight. And in that episode, we looked at some reasons for higher real yields over the long term, more innovative ideas, greater productivity, faster economic growth with plenty of jobs that can lead to higher real rates of interest, along with modest levels of inflation. If there aren't capacity constraints, there's enough capacity to meet demand.

If there are fewer new ideas, population shrinkage, lower productivity, slower economic growth that would lead to lower real interest rates, wouldn't we want to have the former higher real rate because of a robust global economy with more innovation, more opportunity, more jobs? Last week in epo four fourteen, we touched on the sustainability of the national debt, how that could lead to higher interest rates due to an increased term premium, additional compensation, investors demand for uncertainty regarding the federal reserve, uncertainty regarding the federal government and that that could push up interest rates without the the good reasons. The innovation, more jobs, greater productivity, great, could go either way.

And the bankers don't know where interest rates are going to be in the future. The federal serve open market committee, these highly trained economist business practitioners, they make forecast on what they feel, the policy rate, short term interest rates, as represented by the fed funds rate, will be at the end of twenty twenty three, twenty twenty four, twenty twenty five, twenty twenty six. And the longer run.

This is sometimes known as the dot plot. They released a new version at their september meeting in the near term this year, the expectation is between five point four and five point six percent for the fed funds rate. Next year, in two thousand and twenty four, the range is little wider, four point four percent to six point one percent, looking into twenty twenty five and even wider range, two point six percent to five point six percent. And in twenty twenty six, three years from now, the range is expected to be between two point four in four point nine percent, so fairly wide range.

Now how good are forecasters in predicting, at least in the case of the federal open market committee, a rate that they're responsible for setting, and they set rate, as we discussed in the last few episodes, based on whether they want monetary policy to be more restrictive, to slow the economy, to hopefully put some up, put pressure on longer term rates? Or do they want to policy rate to be more accommodate lower interest rates? And that depends on the rate of inflation, capacity constraints, level unemployment, inflationary pressures and all those things.

And so it's difficult to forecast where the economy will be two to three years, and that shows up in the wider range of returns. And IT also shows up in the historical prediction ares looking out two to three years, the rest of air. And that prediction is is been about plus or minus two percent plus.

Remind us two percent around that expected range. So that would suggest a range between zero and six percent for where rate could be in the next three years. Historically, the central bankers and others when you have a policy rate this high will predict that the rate will go down and that, that would put toward pressure on interest rates.

And and that's what we're seeing in the prediction. But sometimes IT reverts to lower rates longer like I did in the early two thousands. Sometimes it's more rapid like in the early nineties.

What we do know though is that looking at where rates are expected be over the next two to three years, maybe even five years, that higher than it's been in the previous five years and certainly in many cases in the past few decades, given worse, looking at interest rates currently for ten year bonds, for example, that they're the highest they've been since two thousand seven. So what are some of these ramifications of higher interest rates that will alter financial blueprint for ourselves, for potentially our business, other businesses? Well, the first is the obvious.

Higher interest rates lead to higher mortality rates, the cost of borrowing to purchase the house, and that leads to lower housing affordability. The average thirty year mortgage ate in the us. As of late last week. The end of september twenty twenty three was seven point three percent. That's the highest it's been since year two thousand.

Housing affordability, the ability to afford a house based on those interest rates, the payments relative to the median family income, assuming a twenty percent down payment that the borrowers puts twenty five percent of the income, told the mortgage payment and they borrow for thirty years that housing affordability is at its lowest level since the early one thousand nine hundred eighties, partially due to higher interest rates, but also because of A A constraint supply in the us. And in many other places around the world of houses, many homes, motors were able to lock in low mortgage rates over the past five years. They don't want to move because then they would have to potentially take out a higher interest mortgage.

So that has made to a reduce supply. Bb, who saying, who was featured in the wall street journal, works for a financial communication firms. He and his fiana rent apartment for three thousand dollars a month in rookley, new york.

They estimate IT would cost a million dollars to buy their house and at current work as rates, that would be a payment of five thousand dollars a month if they put two hundred thousand dollars down. That doesn't even include property taxes, bb says, and its not even that nice of an apartment. So what did he do instead? That is saving for a downpayment.

He decided to spend sixteen hundred dollars on Taylor swift eras tour tickets and thirty five hundred dollars to take a trip her bachelor party to spain. I might as well enjoy what I have now he says he's not the only one that's an anecdote. But the new york fed as a period households spending survey, and in the recent survey, they found that the share of households that made at least one large purchase in the previous four months increased to sixty four percent, its highest reading since aug.

Twenty fifteen. There are more individuals looking at considering how difficult IT will be to purchase a home in the current environment, and they're deciding to spend the money elsewhere taking trips. Demand for travel is up significantly this year and they're spending money, which is one reason the U.

S. Economy is holding a Better than many pundits expected given the high level of interest rates, wilbert vanda claw, who's an economic research advisor on household and public policy at the federal erving said. Normally, at a time when you have higher inflation but also higher interest rates, you don't expect spending to hold up so well.

And IT has the first impact of higher rates is higher mortgage rates and lower housing affordability. And IT altered how people are spending their money because they have less incentive to save for downplaying. A second impact is businesses have greater difficulty in justifying new capital projects.

Last week, the a census bureau announce that starts are shoppers in the grounds for new apartment buildings declined forty one percent in August compared to August twenty twenty two. That's the biggest drop in new apartment starts sits the housing crisis in two thousand seven. Interest rates, higher interest rates do impact that because of the difficulty to borrow, the rates are higher.

They give an example, went developer in denver that builds apartment complexes between one hundred and forty and three hundred and fifty units. They're borrowing costs for new projects has gone from four percent to eight percent. It's doubled.

But IT isn't just the the apartment cost. And one thing we see with higher rates, the impact of that IT IT isn't just the rates themselves. Usually, there are other factors that alter the blue print. In the case of apartment is something we talk to about this past june.

In episode four thirty five, is IT Better to rent or buy a house? And we mention that the supply of new apartments coming online in twenty twenty three and twenty twenty four is really the highest it's been since the eighties because rates have been super low, making IT easier to borrow, and rents have been going up significantly. And that encouraged builds to build more how economics works.

But now those new apartment buildings are coming online that increased supplies is putting downside pressure on rents. There are areas around the U. S. Where rents have not increased in the past year, which is great for renters. But if your business is building apartments and you can't be highly confident that rents will increase when your apartment is done to pencils in the project to justify IT, especially if barring cost of doubled, that discourages you from undertaking that particular project. And that's what we're seeing.

There are fewer apartments that will be built in the next year because of higher interest rates, other project business projects, the hurt rate, the rate return that needs to be generated on the project IT is difficult to meet those hurdle rates. If the business has to borrow money to invest in the capital project because the borrowing cost are higher, a third impact of higher interest rates is especially relevant to us as individual investors, there is a lower risk premium for stocks, bonds and other investments. A risk premium is the additional return that we expect to receive for taking on the risk of invested in the stock market or other risky investments.

The increase return relative to that risk free rate. And that risk for free rate is for thirty day treasury bills, around five point six percent. That's what we could earn right now.

And so when we look at the difference between historical stock market returns and the risk free rate bets, the equity risk premium and the same calculation could be done for bonds realistic and other asset classes. There's a research paper that are link to in the show notes by A Q R S portant folio solutions group. A Q, R is well regarded investment manager that was founded by Cliff asness of credibly smart and funny academic and practitioner.

In their paper, they write, the future path of interest rate is highly uncertain, but we can at least be fairly confident that the level rate will be substantially higher in the medium term. That IT has been in recent decades in the us. And many other major economies.

And that in the point I made earlier in this episode. But they wanted to know what the implications were for these risk premiums. And so they did a study.

They went back in one thousand nine twenty six. They look at the the return for U. S. Stocks and U. S. Corporate bonds.

And they found that when interest rates were higher, the average three year risk premium for stocks was five point six percent compared to when interest rate or lower, that risk premium was ten point four percent. So much higher risk premium when interest rates are low compared to when they were high. Fact, that was twice as high.

The risk premium when interstate for low, same for bonds, corporate bonds, when interest rate low, the risk premium for bonds was two point three percent. When into trades were higher, the risk premium was half that at one point three percent. Before we continue, let me pause and share some words from this week sponsors.

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They have a lower Price to earnings ratio, which is what has happened outside of the U. S. But not in the U.

S. Each month, we get a fresh batch of data for asset camp, our service for analyzing stock index funds. And I looked at the data through september thirty.

Yeah and if we look at the ten year analyzed return for the U. S. Stock market, double did its seven point two percent super high risk premium.

And if we look at the world developed market, X, U. S. Analyzed return has been three point eight percent.

This is for the ten years ending september twenty nine, twenty, twenty three. The U. S. L. Performed over the past decade by over seven percent analyzed what contributed to that?

A big component of the underperformance was valuation changes ten years ago that the yield on ten year government bond in the U. S. Was two point six percent now worth four point seven percent outside of the us.

In the Price to earnings. The ratio went from sixteen point five ten years ago down to fourteen and a half today. And that LED to a one point three percent drag and performance because of lower valuations.

Where's U. S. Talk market got more expensive. The Price to earnings ashe went from seventeen point two. The twenty two point nine that increase the valuation boosted returns by almost three percent analyzed.

So combined the valuation differences with the the nine us skating cheaper, as typically happens when interest rates rise, but the us stock market not getting more expensive. That captures just about a half other return difference. The other big component though is U.

S. Dollars strengthens over the past decade by over thirty percent, and that stronger dollar cause nine us returns to be lower when translated back into dollars by about three percent per year. So that was the other thing.

So if we get a period with a dollar, he stays the same, then we will no longer have that three percent per year drag on an earnest's growth basis, earnings grew at six point seven percent per year for us dogs versus five point three percent for non U. S. So U.

S. Did have higher earnings. And there's something that impacted that stock by backs companies borrowing money and then purchasing shares of the stock in the open market and that can boost earnings per share.

IT definitely has influences U. S. Earnings per share.

In the final driver is a divided yield that was higher outside the three point one percent average given a iee over the past decade versus one point nine percent for the U. S. Stock market.

As I mention, this is from asset camp. Just a quick announcement, bread camp then. And I will be in new orland at fin can and were finalist in fin count annual fin tech competition.

And so have a booth fair will make a presentation showing off a asset camp and meeting with lots of financial influences spreading the word about this tool we're excited about that is the third impact of higher interest rates, a smaller risk premium 和 risk your assets。 The fourth impacts, the stock market is fewer stock by backs, which I i've just described. Companies that make up the S P.

Five hundred spent one hundred and seventy five billion dollars in the second quarter twenty twenty three purchasing their stock, buying back chairs. That was a twenty percent decline from the same quarter a year ago and IT was a twenty percent decline from the first quarter. Twenty and twenty three.

Jill kerry hall, who is an equity and quanta text st at bank of america, said structural reasons as well as the interest of environment are both contributors when rates for zero IT made sense for companies to issue long dated low rate debt and use IT to buy blackshaw, not so much now. And so the expectation is higher rates will lead to fewer stock by bags, which because that boost only per share, we could see potentially lower earnings growth per share for U. S.

Stock market, which is a primary driver of returns. Corporate buybacks are not without controversy. And in this environment, there's potentially more demand to make these capital project, particularly as many companies focus on how ai is going to impact their business and what additional investments in capital projects they need to make.

Incorporate A I U S stock by bags s have been so controversial that the government passed a one percent tax on buybacks to encourage companies not to buy back to stock, but to invest in projects. A fifth impact of higher interest rates is a little more complex. It's potentially higher expected returns for some more esoteric investments in that study that A Q R did.

They did a shorter time frame also from one thousand nine ninety through mid june twenty twenty three and IT. IT showed the same trend for stocks and corporate bonds, lower risk premium when rates or higher, but they included some other asset classes, also private equity, so leverage buyout funds, venture capital, the excess return for private equity was fifteen percent when rates were lower, but only six and a half percent when rates were higher. Real estate, the risk premium was nine point five percent when rates for lower and three point three percent when when rates were higher.

But there was one strategy that did Better when rates were higher, something called trend. Following the risk premium, there was six point seven percent, one rates to a higher and four point four percent rates for lower trend. Following is a strategy where an investor uses derivatives such as futures or options to get exposure to an area.

The market could be commodities, could be currency IT could be stocks. Whatever is doing well, IT IT will go long those sectors and then IT can go short areas that are selling off. And the idea is to be hopefully, it's not always market neutral.

IT will have a bias, but because they're using futures or options, there's ebel ded leverages there. These strategies are sometimes called manic futures, and they tend to have high cash exposure due to the embedded leverage in purchasing futures or options. So you have have a margin account and that's invested in cash.

And so when cash has generating higher yield, these are sometimes known as cash plus investments that will lead to higher returns, at least protect the returns when IT is rates are higher. And so this is one strategy that does well. Now IT is complicated and it's very, very difficult.

This is an active strategy. IT takes an informational edge casually. I'll look at A Q R S funds.

They have a vehicle. They have the A Q R managed future strategy fund. It's expensive. The expensive is one and a half percent.

If we look at the return since inception january fifty, twenty ten, only return two point seven percent analyzed. In the past year, it's up two point two percent. So even though we have higher interest rates, the fund is not kept up.

The best period was three year returns, thirteen percent annualized, five years, six point one percent. And so there has been times it's done well as times it's not done as well. But we're talking about the underlying principle here.

And the principle is that the higher cash fields makes IT easier. There's a tail wind for these type of strategies. We see IT in the to a bank commodity tracking etf, D B C.

This is a more of passive exposure to commodities. Over ninety percent of that etf is invested in cash fielding investments because it's getting exposure to a variety of commodities, but most of the asset to invested in cash. And so the return is the thing what the commodities do plus that cash was some other elements, but that's the point.

There are certain strategies that do Better when cash yields are higher. The six point than is higher interest rates lead to higher financial opportunity cost. And this is really important for us as individuals.

Opportunity cost are what we give up when we choose to do something or purchase something. There are alternative choices we could have made when cash was earning zero, the opportunity cost are lower. But when cash over five percent, then the opportunity cost are higher in that, that means an opportunity cost for not investing in cash is higher.

When rates are higher that the hurdle rate IT could be. As investors, we can meet all our objectives, earning five percent on cash. And so they expect to return on talks or other risk assets has to be higher, the net higher than historical the risk premium.

But we ve already seen it's not it's actually lower when interest rates are higher. I saw one couple there was featured in the wall street journal. They went out recently after he quit her jo B2Be a f ul l tim e car egiver and bar red mon ey to tak e a t ri p to haw aii.

They spent ten thousand dollars on a credit card, including a thousand dollars for last minute plane tickets, and ten nights at a three hundred and eighty five dollar per night force our resort, elaborate meals that point IT out. And now they're coming back and they're cancel subscriptions, are cutting back on dining out and they were glad that they win and i'm sure they had a great time, but that's disastrous opportunity. Cost of that even greater because in this case, we're not just giving up a five percent, we turned on cash, but we're taking out debt, credit card debt with interests of twenty percent or more potentially.

But he feels seductive because we can get IT immediately. But we are dissatisfied. Huge opportunity cost of not earning that five percent cash in conclusion, then higher casuals, higher real returns with moderate inflation is a boon to savers and investors.

We can earn over five percent for risk free investments. No doubt that hurts first time home buyers. Companies are also having to be more discipline and how they allocate capital. There are fewer stock buybacks, higher hurdle rates for capital projects as individual investors, we need to be aware because cash ids are hire that financial opportunity across the higher, the opportunity cost of the saving and taking on debt is higher.

The reward for taking on equity risk is lower, not that we shouldn't invest in stocks or take other financial risk, but we need to understand that the opportunity cost is higher. Now we have positive your rates and we can learn five percent cash. We don't know how long rates will be this high.

IT does appear it'll be for the next several years. And with inflation coming down, that is made IT very tractive because we're getting positive your returns to be aware of the opportunity cost of not in cash as we make our financial choices in the months and years ahead. That's episode four fifty.

Thanks for listening. I have loved teaching you about investing on this podcast for over nine years. Some topics though I just Better explained in writing or with a chart.

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