The Movement of Interest Rates Is So Much More Complicated Than We Think

The theory sounds simple enough. The United States Federal Reserve has been buying huge quantities of US Treasury bonds over the past few years through its Quantitative Easing (QE) programme, pushing interest rates down.

With the Fed having tapered its monthly bond-buying from US$85 billion a month to its current level of US$65 billion – and with expectations of even more tapering to come over the year – it’s easy to conclude, in theory, that interest rates would move up given the gradual decline of a strong buying presence in the Fed.

But, theory does not always mesh this cleanly with reality as this clever quip attributed to baseball legend Yoggi Berra goes, “In theory, there is no difference between theory and practice. In practice, there is.”

Back in 30 November 2013, I wrote an article titled Where Will Interest Rates Be? questioning if interest rates would actually rise if the Fed decides to cut down on QE. I was of the stance that while it’s likely that interest rates might rise, it was far from being a sure thing.

According to Bloomberg, US 10-year government bonds were yielding 2.74% back then and the taper in QE wasn’t even announced yet. Fast forward to today, after a US$20 billion reduction in QE, we find US 10-year government bonds yielding 2.61% instead – interest rates have fallen.

Isn’t that weird? But as it turns out, that wasn’t the first time interest rates have fallen when QE was reduced or stopped. In the five years between the start of 2008 and 2013, the US Fed had stopped its QE programme on occasions and in my article, I referenced my American colleague Morgan Housel’s work, which showed how interest rates on US 10 year Treasurys rose when the US Fed stopped its QE programme, every single time.

Morgan’s explanation basically boiled down to the market “pric[ing] in events before they actually happen.”

This is tangential to a sentiment that Howard Marks, co-founder and chairman of Oaktree Capital, has. Oaktree Capital has over US$83 billion in assets under its management and over the 22 years ending 2011, the firm’s various funds have averaged 19% annualised returns net of fees; such a track record would make Marks’ views on investing well worth appreciating for any investor.

In a recent interview with Swiss Finanz und Wirtschaft, this what Marks had to say on the topic: “Most people agree that there is a very high chance that the Fed will continue to taper its bond purchases. But we don’t know what the effect will be. In other words: Everybody thinks tapering will make interest rates rise. But maybe interest rates already have risen in anticipation of the tapering, so that the event of the tapering itself will not cause a rise. One thing you can never be sure of in the investment world is <<if A, then B>>. Processes and linkages are not always predictable.”

This brings home the point that the way interest rates would eventually react to the US Fed’s posture and actions can actually be a lot more complex than what most think it is.

But crucially, should all these uncertainties about interest rate movements stop investors from investing in the stock market at all? Your mileage might vary, but for me, the answer’s a definite no.

For starters, some studies have shown how there’s no historical correlation between interest rate movement and subsequent stock market prices. Furthermore, stock prices rise over the long-term because of the growth in profits and cash flows a business can generate; a quote attributed to billionaire investor Warren Buffett sums it up succinctly, “If a business does well, the stock eventually follows.”

That’s not to say however, that investors should not pay notice to the amount of debt that a company’s taking when they’re making investing decisions. There’s a huge range in the amount of leverage different companies are taking and a quick glance at even the 30 companies within the Straits Times Index (SGX: ^STI) can give you an idea of that.

For instance, the total debt to equity ratios range from 0% at Singapore Exchange (SGX:S68) to 831% at Starhub (SGX:CC3). The table below contains a few more shares within the index that showcase the range of leverage that Singapore’s blue chips have assumed.


Total debt to equity ratio

Singapore Exchange


SIA Engineering (SGX: S59)


Wilmar International (SGX: F34)


Olam International (SGX: O32)


Source: S&P Capital IQ

While it might be unclear as to how interest rates would move if/when the US Fed completely removes its QE programme, it’s not at all unclear that, all things equal, heavily-leveraged companies would face much greater financial risks than less-leveraged ones.

Foolish Bottom Line

All told, we should leave the prognostication of interest rates to others. But at the same time, while keeping an eye out for dangerously-levered balance sheets in companies, we (as investors) should not be scared out of the stock market for fear of rising interest rates. Nobody really knows where interest rates will go to and good businesses would likely continue making substantially higher profits 10, 20, or even 30 years later. And as investors, it’s the good businesses that we really want to focus on.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.