Q3 2020: Zero Interest Rates… Here For The Taking
On more than one occasion we have utilized this valuable real estate to discuss interest rates and their impact on, well, really anything that has to do with the economy. So, when the Federal Reserve lowers the fed funds rate to ZERO, it’s worth noting. And when they go onto to say they would keep this rate near ZERO for as long as it takes the economy to recover from the coronavirus crisis, it’s worth writing a monthly newsletter about it. Not only to explain its historical significance, but more importantly, it’s impact on us as individuals.
This is newsworthy as the Federal Reserve laid out a policy that should spur higher inflation. This differs with the typical balanced approach where the Fed lowers interest rates to spur economic activity and then will increase rates when growth accelerates (driving higher inflation).
Now, regardless of rising inflation (whenever that may happen), the Fed has said they will remain on the sidelines and allow higher interest rates to persist. In the words of the Fed, they will let inflation run “moderately above 2% for some time.” (For those keeping score at home, 2% is the Fed’s standard target rate for inflation.)
That’s the current state of the Federal Reserve’s policy on the fed funds rate. They want to see the economy grow again (i.e., create jobs) and they are willing to risk higher inflation to see it happen. When will we reach this level of robust economic activity? Who knows! As the great Peter Lynch once said: “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” Needless to say, we agree.
Zero percent will impact the overall economy, but it should have an even greater impact on us as individual investors and consumers. For the latter, the historically low fed funds rate will impact consumers’ borrowing rate. Whether it’s a home loan, student loan, auto purchase or credit cards, you have an opportunity to lock in some crazy low rates that should help drive the growth of your assets/investments.
For instance, take your home mortgage. If your interest rate today is in the 4% - 5% range, you now have the opportunity to refinance down to the 3% range, if not lower. Not only will you be paying less for your home (i.e., lower interest), you can invest this monthly savings.
Let’s say you have a $600,000 mortgage and you refinance from a 4.5% rate to a 3% rate; your monthly savings will be just over $500. If you take this savings, invest it and your money grows at the stock market historical annual return (i.e., 9%+), this savings will grow to just about $100,000 in 10 years. If you held this loan for its entirety (30 years), the invested savings will climb to just under $1,000,000 ($941,581 to be exact).
The beauty of this is it has nothing to do with the economy. The ability to lower your cost structure and subsequently invest the savings is in the consumer’s hands. Whenever the economy rebounds, it has nothing to do with your personal situation. Zero rates will definitely impact us, the consumer.
For the individual investor, zero interest rates may have an even greater impact as they affect thousands of companies. Just as a consumer has the opportunity to lower their cost structure, the same opportunity exists for businesses on a larger scale and at lower rates.
As homeowners, banks loan us money based on our creditworthiness and the value of our main asset… our home. For Corporate America, these companies are granted funds by selling bonds that is based on the creditworthiness of their business (i.e., cash flow). For the best companies, their interest rates are hovering around the 1% - 2% range for even long dated bonds (i.e., payable over 30 – 40 years)!
For example, about a month ago, Google (Alphabet) raised funds by selling bonds that mature in the year 2060 and the interest rate is 2.25%. Unreal! Did they need billions of dollars in capital? Goodness no… they had 30 billion dollars of free cash flow last year! But, just as we, the consumer, take advantage of low rates, so do smart companies.
Google raised that capital because interest rates are so low and they are confident they can produce a return on capital that is greater than their cost of capital (i.e., 2.25%). As investors, we seek the historical returns of the stock market (9% range). According to our analysis, Google historically has a return on capital somewhere in the 20% range.
So, as long as management produces services customers demand (and will pay for), there is a high likelihood, they will create real value when their capital cost is 2.25% and their expected return is 20%+. This real value (i.e., earnings/cash flow) will ultimately drive the market value of the company resulting in gains to us, the investors.
Regardless of current market valuations, the best companies in the world should thrive in this ultra-low interest rate environment. And overtime, as the business grows, there will be shareholder value created, whether through stock appreciation or dividend payouts.
As investors, consumers, and business leaders for that matter, the Federal Reserve is essentially forcing us to participate in the effort to reinvigorate this economy. As mentioned above, we don’t know how long rates will be this low (i.e., we are not economists), but we do know they are here now for us to take advantage.