Interest Rates

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This article describes the impact of interest rates. A related concept is the Yield Curve.

An interest rate is the cost of borrowing money. Among the many industries affected by fluctuations in interest rates, real estate and banking are perhaps the most directly impacted. When interest rates increase, borrowing becomes more expensive, dampening consumer demand for mortgages and other loan products and negatively affecting residential real estate prices. Rising interest rates can also lead to increased default rates, as holders of adjustable rate debt find themselves faced with higher payments. Vendors of mortgage backed securities, which consist of bundled mortgages, will see their ability to monetize the securities lessens as a result of the deterioration of the quality of the underlying asset.

At any given time, there are a number of interest rates available in the economy. Interest rates vary across the size, risk, duration, and liquidity of an investment. The interest rates for various durations of investments (short- to long-term) are called the Yield Curve.

Why Interest Rates Rise and Fall

There are two main determinants of interest rates - the Supply and Demand for Money :.

Changes in Money Demand alter the Interest Rate

The opposite side of the Money Supply (controlled by the Fed) is Money Demand. Because money is perfectly liquid, it is easily converted into other goods. Thus, during certain situations, it is preferable to hold more dollars (instead of say stocks) since there is little risk of them falling in value and they are easily converted into other goods. In particular, the demand for money rises when: consumer spending rises, uncertainty rises, there are higher costs in buying and selling other assets, expectation of a future stronger dollar, increased demand for reserves from central banks (both foreign and domestic), and a rise in foreign demand for US goods and investments. Each of these aspects push up the demand for US dollars while the reverse decreases the demand for dollars. A rising demand for money, all else constant, will raise interest rates while the converse is also true. The opposite can also happen during times when the market becomes averse to riskier assets because investors will move into the dollar and U.S. debt in a search for safety.^[1] The demand for money, combined with the Supply of Money determine interest rates. This framework for understanding interest rates its known as the Liquidity Preference Framework, with the Liquidity Preference Curve being the Demand for Money curve. Since currency is the most liquid store of value, its demand demonstrates the demand, or preference, for liquidity.

Money Supply and the Fed=

Interest rates rise or fall largely as a result of the amount of money in circulation at any given time. The Federal Reserve Bank of the United States affects both short term and long term interest rates by manipulating money supply through open market operations, changing reserve requirements for banks, or changing the rate at which it loans out money to banks. The former involves purchasing large volumes of government securities, in order to increase money supply (driving interest rates down) or selling large quantities of government securities in order to decrease money supply (driving interest rates up). The Fed can also raise the reserve requirement for banks, increasing the amount that banks have to hold against loans, and decreasing the amount that they can loan to the public.

Why the Fed Alters the Interest Rate

Two important factors affect the Fed's decision to raise rates: inflation and the overall health of the economy. When inflation is too high or increasing too rapidly, the Fed may raise rates in order to slow the economy and trim inflation. Conversely when the economy is doing poorly the Fed may cut rates in order to promote stronger growth at the expense of low inflation.

US Deficit and China

Although far from certain, there is speculation that the United States fiscal deficit can impact interest rates. In order to fund deficits the government has to issue increasingly large quantities of debts. The government’s continuing demand for money has the potential to crowd out private investors, resulting in higher interest rates. In other words as the government borrows more money, there are fewer funds available to private investors, and as demand exceeds supply, interest rates rise.

China limits the appreciation of its currency by using US dollars gained through its export activities to purchase US debt. By providing the US government with a willing buyer for its debt issuance and paying for this debt in US dollars, China increases money supply and thereby lowers US interest rates. A reduction in the amount of debt purchased by a country, China and India in particular, could have an impact on US interest rates.

Companies that are hurt by rising interest rates

• Banks like Citigroup, Bank of America, and Wells Fargo (WFC) derive a large percentage of their income from net interest margin. As interest rates rise, banks are forced to pay higher rates on deposits and other interest bearing accounts. Meanwhile consumer demand for mortgages and other loan products diminishes as borrowing becomes more expensive. The combination of these two effects reduces both the volume of loans and the profitability of each loan. Rising interest rates also have the potential to increase a bank's defaults as holders of adjustable rate mortgages find themselves unable to meet their obligations. This is especially true of Subprime borrowers .

• Home Depot (HD) and Lowe's Companies (LOW) which sell home construction and improvement materials are hurt. When interest rates rise fewer homes are built and fewer home improvement projects are undertaken. Refinancing, a major source of funds for home improvement projects, also becomes more expensive. However, individuals may decide to remodel their current homes rather than purchasing new

• Investment Banks like Goldman Sachs Group (GS) and Morgan Stanley (MS) derive a substantial portion of their revenue from the facilitation of debt issuance by companies and the sale of mortgage backed securities. In a rising interest rate environment the demand for both products diminishes.

• Vendors of wireless internet services such as Time Warner Cable and Comcast (CMCSA) are harmed by rising interest rates because higher interest rates typically result in lower levels of new home construction. Given the high level of penetration in the existing homes for internet and cable, new home construction represents a critical driver of internet and cable sales.

• Toll Brothers, Lennar Corp., and Pulte Homes are all leading companies in the residential construction industry. Decreased home construction would harm companies such as these due to the reduced demand for their products.

• Sears Holdings, Whirlpool, General Electric, and other appliance manufacturers would likely see decreased demand for home appliances as a result of falling new home construction.

• Plum Creek Timber Company, Weyerhaeuser, and Louisiana-Pacific, as well as other producers of lumber and other wood-based building materials, would be hurt by falling new home construction in a rising interest rate environment.

• Black & Decker and other companies that manufacture construction tools are largely dependent on new home construction for product demand growth. Lower rates of residential construction would hurt companies such as BDK.

• Real Estate Investment Trusts (REITs) such as Vornado Realty Trust (VNO), EQUITY RESIDENTIAL (EQR), Apartment Investment and Management Company (AIV), BRE Properties (BRE), Camden Property Trust (CPT), United Dominion Realty Trust (UDR), Brandywine Realty Trust (BDN), and Liberty Property Trust (LRY) are hurt by rising interest rates since it becomes more difficult to sell real estate and likewise alternative investments such as bonds become more attractive relative to real estate, so real estate prices tend to stagnate.

• Fidelity National Financial (FNF), First American (FAF), and other Title Insurance underwriting companies are hurt by rising interest rates because as fewer real estate properties are sold, fewer Title Insurance policies can be sold, reducing the revenues for companies dependent on premiums from issuing Title Insurance policies.

• Companies that have significant amounts of debt are hurt by higher interest rates, which force the company to spend more money each year to repay their debt. Additionally, companies may find it difficult to refinance their debt if interest rates rise. However, if they issued long-term debt at low rates, they could definitely benefit from rising rates by paying lower interest on debt than their competitors who may issue debt at much higher rates.

Companies that Benefit from Rising Interest Rates

• Large depository institutions suchs as Bank of America, JP Morgan Chase and Citibank may benefit from rising rates when the shape of the Yield Curve becomes steep, i.e. when the difference between short term interest rates and long term interest rates is large. Depository institutions make money by borrowing short and lending long; they collect the spread in between. When the spread is large, their net interest margin increases as do profits.

• Online brokers may be helped by rising interest rates because they benefit from higher net interest margins on deposit accounts. It should be noted, however, that these companies may be hurt if higher rates result in depressed market activity. Companies in this category include Charles Schwab (SCHW), E*TRADE Financial (ETFC) and TD Ameritrade Holding (AMTD) etc.

• Insurance companies may also benefit from rising interest rates, because much of their profit is earned on the float, the period between when premiums are collected and claims paid out. During this time, insurers invest the premium. Rising interest rates imply a higher return on bonds, one kind of investment, although higher rates lower the value of bonds currently in their portfolio. Large home insurers such as Allstate (ALL) benefit more than do smaller auto insurers like Progressive (PGR) or Geico.

Companies that Benefit from Wider Interest Rate Spreads

Interest rate spread refers to the percentage differential between the risk-free Treasury rate and the rate on other, riskier fixed-income securities. Companies that benefit from wider (i.e. bigger) spreads are:

• Assurance/guarantor companies, who provide insurance against default. Generally, wider spreads indicate a perceived higher risk of default, so these companies can earn higher premiums on issuances since purchasers of these "credit enhancement" products will pay more for them. Some examples are:
• MBIA (MBI)
• Ambac Financial Group (ABK)
• Financial Security Assurance Holdings (FSE)

• Banks and financial institutions, who borrow and lend at different rates and maturities (e.g., the classic model of borrowing short and lending long). Their net interest income or margin (difference between interest income and expense) is susceptible to yield curve changes, both level and shape.

References

1. ↑ About.com - Economics "What is the Demand For Money?"
2. ↑ Board of Governors of the Federal Reserve System: Monetary Policy, Open Market Operations