When shopping for sale items, it’s customary to look at the price tag and see how much an item has been “marked-down”. You’d rather browse the “30% off” rack than the racks with lower discounts. Why? Because it affects the item’s value. On a much more sophisticated level, stock values and interest rates have a similar relationship. In a recent Wall Street Journal article, Jason Zweig describes how interest rates are an important factor when determining the intrinsic value of investments (the current value of the cash they are likely to generate in the future).
Here’s how it works: If you can earn a solid return on the safest type of asset (the so-called “risk-free” return), you’ll want a much higher return if investing in a riskier one. As the risk-free rate falls, however, you’re more willing to gamble on an asset delivering a higher return down the road. As explained by Robert Litterman of Kepos Capital, “If the risk-free rate is lower, everything else being equal, that makes the same cash flows in the future worth more today.” So, with the current 10-year Treasury yield sinking below 1.6% (0.2% if adjusted for inflation), investments have become more expensive.
Risk also increases as rates fall because capital appreciation becomes a bigger contributor to a stock’s return, so the success of your investments are more heavily anchored to a continued bull market. Further, low rates can impact a company’s worth if valuations are based on mismatched interest rate figures. That is, if analysts use past, higher rates to extrapolate earnings but then use current, lower rates to discount future cash flows, a stock’s value will be grossly overstated.