The Federal Funds Rate
Directly or indirectly, you're probably well aware of when the Federal Reserve (the Fed) meets to discuss interest rates. Directly, of course, it's mentioned in nearly every news publication. Indirectly, you're likely to see the eager anticipation of the Fed's looming decision in the form a very jittery stock market.
But why is this? What is the connection between the interest rates the Fed meets to discuss and the stocks in your equity portfolio?
The term interest rate refers to the cost of using of someone else's money. We're exposed to interest rates in various forms - from mortgages to credit cards, and a whole slate of other venues.
For investors, the interest rate of concern is the Federal Funds Rate. This refers to the interest rate at which depository institutions lend their balances (federal funds) at the Federal Reserve to other depository institutions overnight in the event those institutions need additional money in order to keep their reserve at the Fed at the required level. Manipulating the Federal Funds Rate, by way of open market operations (buying and selling of bonds), is one way the Fed attempts to control inflation. An increase in the Federal Funds Rate is the Fed's attempt to lower the supply of money - making it more expensive to obtain, thereby curbing inflation.
So what does this mean for investors?
The prevailing method of valuing a company - discounted cash flow (DCF) - is to sum all expected future cash flows discounted back to the present. An increase in interest rates lowers the DCF valuation of a particular firm. Additionally, given the higher interest rates, firms are less inclined to borrow money to fund growth. This lowers the future cash flows of the firm, once again lowering the intrinsic value of a firm based on DCF.
As people's perception of the value of a firm is lowered, so too will the price of the firm's stock. Investors want to see their invested money increase in value. To most, gains can come in the form of stock price appreciation, dividends, or both. With lowered expectations for both growth and future cash flows from a particular firm, investors stand to benefit less from stock appreciation, making owning stocks less desirable.
Investors always seek out the maximum return for a given amount of risk. When the Fed raises rates, government securities, such Treasury bills and bonds, are often viewed as the safest investments. Specifically, the "risk-free" (the U.S. Govt. is unlikely to default) rate of return goes up, making these investments more desirable than stocks, which are inherently risky.
As the risk-free rate goes up, the total return required for investing in stocks usually increases. This occurs because investors need to be compensated for assuming the additional risk found in equities, or a premium above the risk-free rate, coined the risk premium. If the required risk premium decreases (likely to occur because of expected lower cash flows) and the total return remains the same or lower, investors may feel that stocks have become too risky, and will put their money elsewhere -- the effect of which you're likely to see on your portfolio holdings when the Fed is meeting and is expected to raise rates.
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