Or, what we talk about when we talk about interest rates

It’s the first commandment of the stock market: don’t fight the Fed. And for good reason.

The Fed plays a key role in setting interest rates. And interest rates are a key ingredient — at times the key ingredient — in the method that virtually all investors, analysts, and automated-trading models use to value stocks. 

This method, known as discounted cash flow, or DCF, analysis, can be boiled down to one simple idea. Stock prices = expected cash flows x by a number known as a “discount rate.” All else equal, higher discount rates = lower stock prices. Lower discount rates result in higher stock prices.

That might seem simplistic, and it is. But it’s a powerful bit of knowledge about how Wall Street works. It’s also a big reason the Fed has such a massive impact on the market. 

So… what are discount rates?

Well, there’s a long, rambling theoretical answer to that. It’s a philosophical digression concerning the nature of reality, the costs of uncertainty, the value of time, and the meaning of value itself. If you want to dive in, here’s a great synopsis of some of the issues.

But nobody on Wall Street cares about the theoretical side of discount rates. So, for our purposes, let’s just say discount rates are the number you plug into your DCF formulas.

How do I figure out the right discount rates?

Basically, you come up with this number by adding the interest rate on a US government bond to a mysterious additional few percentage points, a bit of mathematical wiggle room known as a risk premium. Boom — discount rate.

Here’s the thing. While there are a ton of different variables that analysts and investors can add to their particular recipe for valuing stocks, interest rates on US government bonds are basically the universal ingredient. This is why interest rates are such a big deal for the market. 

Wait, what’s all this about government bonds? I thought the Fed controlled interest rates. 

So, this is always a bit confusing. And we don’t help things much in the financial press by throwing the term “interest rates” around indiscriminately. But in our defense, there are a bunch of different kinds of interest rates that are all related.

In the simplest terms, “interest rates” are borrowing costs, expressed as a percentage or rate.

There are as many different interest rates as there are borrowers.

Credit cards. Municipal bonds. Mortgages. Small-business loans. Multibillion-dollar corporate-bond deals. They all come with their own individual interest rates.

But all these different interest rates share a foundation. They’re all based partly on the yield on US government bonds, known as Treasuries. Yields on Treasuries are effectively the interest rates that the US government pays when it borrows in the market. On Wall Street, government-bond yields are referred to as “rates,” a shorthand reference to their importance as, basically, where interest rates for the entire economy come from. 

Does the Fed determine the interest rate Uncle Sam pays?

Not quite. The interest rates that the Fed decides on at its big meetings — aka the Fed Funds rate — basically governs the short-term lending markets that banks use. Banks need to borrow funds overnight to make sure they have the reserves that the government mandates they have, and to ensure they have the cash they need for customers to withdraw.

The Fed essentially controls these short-term interest rates. But the US government doesn’t borrow directly at these rates.

Who decides what the government pays to borrow?

That gets decided, in part, by the government-bond market. The US government has some $25T in debt securities that are traded in financial markets. And the opinions of investors in those markets about the rate that will persuade them to hand over their cash to the Federal government plays a big role in determining those interest rates.

So investors determine the bond market?

Well, not entirely, or even sometimes primarily. The government-bond market is also heavily influenced by the Fed, and what investors think the Fed is going to do with short-term rates over time.

To make things even more complicated, from time to time — like, say, during major crises such as the Great Recession of 2008 and the pandemic — the Fed itself starts buying government bonds in the market, and plays an even bigger role in determining yields — or interest rates — on government bonds, and therefore discount rates plugged into models.

So, it’s not right to say that the Fed decides on the rate the government pays. It does play a role — at times a giant role.

How does all this work in practice?

Well, we just saw how last week. On Wednesday, we got a hotter-than-expected CPI inflation report for March. Persistently high inflation seemed to make it a lot less likely that the Fed would cut rates over the next couple of months, and perhaps a lot less than people thought over the next few years.

As a result, there was a big jump in the interest rates in the government-bond market. Everybody in the financial world saw those higher rates and quickly moved to plonk those higher rates into their DCF formulas.

Discount rates mechanically rose. And as we know, all else equal, that means lower stock prices. And these new lower price estimates for the market were almost immediately reflected in a market sell-off.

Presto: the worst week of the year for stocks.

It’s not because there was a sudden mass realization that companies will make less money in the future. (Remember, cash flows are the other part of the DCF formula.) It’s just that interest rates went up sharply.

How can this be? Is it true that stocks are worth less just because rates go up?

I’ve asked this question of Wall Street people over the years. Usually what you get back is a blank stare. It’s sort of like asking a seasoned political operative if they're doing the right thing, morally speaking. It doesn’t really compute.

That doesn’t mean there’s not some logic behind DCF analysis. One way to understand DCF is as a formalized approach to thinking about the trade-offs between investing in risky stocks or super-safe Treasury bonds. 

Theoretically, when government bond yields rise, it becomes more attractive for investors to put their money in these safe investments. That siphons money out of stocks and into bonds, and stock prices fall. 

That all sounds logical enough. The problem is there’s no real way to test the theory. You can’t survey all investors about if, and why, they moved their money out of stocks and into bonds. All we know is that when rates rise, stocks tend to fall.  

Not for nothing, but personally, I think the answer is no. It is not true, in any objective sense, that when rates rise, stocks almost mechanically are worth less. It’s just a widely used convention. 

But on Wall Street convention is a powerful thing. And in the world of finance — one of the more cynical arenas of human endeavor, mind you — belief in the value of discounted cash-flow analysis is pretty much the closest thing I’ve ever seen to a genuine article of faith. 

It’s possible that this way of thinking has become so pervasive that it has sort of shaped the way markets actually behave. (Before you laugh, there’s a whole subset of sociology that studies the way models actually can warp the economic and market outcomes they’re simply supposed to describe.)  

At any rate, it doesn’t really matter whether DCF analysis is objectively “correct” or not. It’s incredibly important for all investors to understand, which is why we went through the effort of trying to explain it. 

Of course, phrase “don’t fight the Fed” will probably serve you just as well.