A quiet summer has ended and markets have moved up and down the last few days because of interest rate chatter again. Will the Fed raise rates for the first time this year following last December’s .25% move? After years of experimenting with near zero and then beyond to negative interest rates, central banks may be starting to realize that people are saving more money because of low interest rates instead of spending more money because of low interest rates. This reality is different from what I was taught in Economics 101.
Note: 2015 data is preliminary and 2016 is projected - Sources: Wall Street Journal, OECD
So if raising interest rates is possibly good for the economy, then why does the market seem to drop when that is the headline? The answer is because interest rates are a variable in every asset valuation equation out there. The simplest is the Dividend Discount Model where the price = the annual dividend/the discount rate or interest rate. Imagine the plainest stock in the world, paying $1.00 a year in dividends. If the interest is 8%, the stock is worth $12.50. If it’s 8.25%, then it’s worth $12.12, or 3% less. On most days, this dominates the market as increased consumption and economic confidence of higher rates will take months to show up at the cash register (or checkout button).