Obsessing Over Interest Rates

Obsessing Over Interest Rates

“The theory of interest bears a close resemblance to the theory of prices, of which, in fact, it is a special aspect. The rate of interest expresses a price in the exchange between present and future goods. Just as, in the ordinary theory of prices, the ratio of exchange of any two articles is based, in part, on a psychological or subjective element—their comparative marginal desirability—so, in the theory of interest, the rate of interest[…] is based, in part, on a subjective element[;] namely, the marginal preference for present over future goods. This preference has been called time preference, or human impatience.” –Irving Fisher, The Theory of Interest

Investors are somewhat obliged to be obsessed with interest rates. They touch every aspect of financial markets and, arguably, every aspect of modern life.

I like the quote from Irving Fisher above, particularly the bit about human impatience. Interest rates represent the cost of time. Impatient borrowers can pull the future forward into the present by paying for the privilege to access a lender’s savings for a period of time.

Both the lender and borrower use the rate of interest to assess the efficacy of this time travel. For the borrower, they have to decide whether or not the cost is worth the ability to consume or invest more today; for the lender, they have to decide if the compensation provided is worth the opportunity cost of forgoing consumption or some other investment today.

Many investors seem to have the knee-jerk assumption that lower interest rates are preferable to higher interest rates. The casual implication is that economic growth transpires from the lower cost to borrow money and asset prices benefit from discounting future cash flows at a lower rate.

But let’s go back to the basics. There are two parties involved in every financial transaction. Low rates may be great for the borrower (at least in the short term), but they’re not ideal for the lender!

When interest rates are low, capital allocation gets sloppy. Both borrowers and lenders embark on financial transactions that often destroy wealth as the rate of interest imposes no discipline on either party. Everything looks like a good idea when there are no apparent tradeoffs or opportunity costs associated with an investment.

True wealth and economic growth are not the result of cheap borrowing. Wealth is created when entrepreneurs develop better, more creative ways to build and deliver goods and services that other people value. When there is (some) cost to getting the entrepreneur’s project off the ground, capital is more likely to flow to the best ideas.

For example, when the cost to borrow is 8% instead of 2%, the hurdle rate is higher for both the entrepreneur and the investor to create real economic value – in this case, a return on invested capital greater than 8%. Projects that only generate a 3% return on invested capital are not worth pursuing if the cost of capital is 8%. A meaningful hurdle rate enforces discipline on the part of the entrepreneur and the investor, and that discipline results in more meaningful wealth creation for society over time.

Investors have been hyper focused on interest rates over the past few years as inflation took off and the Federal Reserve embarked on a campaign of raising rates to combat that inflation. As we head into 2024, inflation has cooled considerably, and the Fed is likely done hiking rates and may even start to lower rates this year.

Wherever we land, my hope is that we’re not headed back to the era of “zero interest rate policy” that defined the decade coming out of the Great Financial Crisis. Low interest rates are not the lifeblood of the economy. If anything, a higher level of interest rates is reflective – all else equal – of healthier economic growth and wealth creation.

 

Advisory Services offered through Peak Asset Management, LLC, an SEC registered investment advisor. The opinions expressed and material provided are for general information, and they should not be considered a solicitation for the purchase or sale of any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This content is developed from sources believed to be providing accurate information and may have been developed and produced by a third party to provide information on a topic that may be of interest. This third party is not affiliated with Peak Asset Management.  It is not our intention to state or imply in any manner that past results are an indication of future performance. Copyright © 2023 Peak Asset Management

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