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An excerpt from Doug Henwood's Wall Street (Verso, May/June 1997) on the relations among interest rates, speculation, and reality.

Mother Credit

If there is a mother of all markets it is the one for credit. Changes in the terms on which some people let other people use their money move both the financial market and the real economy. When credit is easily gotten, and when interest rates are low and/or falling, the financial markets typically sizzle; when credit is scarce, and rates are high and/or rising, financial markets do badly.

Why is this? Several reasons, the simple ones first. The focus is on stocks, which are often the focus of speculators' most ardent attentions, but it can be applied with only slight modifications to other assets, like real estate, art, and baseball cards.

Cost of playing with other people's money. Speculators - and the word here is used in a morally neutral sense to mean anyone who buys a financial asset in the hope of selling it at a higher price in the near or distant future - typically operate on borrowed money. Any increase in the cost of their funds increases the costs of their doing business, with obvious effects on their enthusiasm and buying power. Someone who borrows money at 5% needs to make well over 5% to justify the great risks of holding stocks or futures - say, just for the sake of argument, 10% or more. Should rates rise to 7%, the margin of safety at a hoped-for 10% return would be reduced, meaning that a return of 12% would be required. And returns of 12% are much rarer than 10%, rare as those are. Consequently, speculative enthusiasm dampens, and prices sag.

Effects on sentiment. When interest rates rise or fall a nontrivial amount, it's usually with the consent or even the intention of the central bank. When central banks lower rates, they're trying to stimulate the real and financial economies; when they raise rates, they're trying to slow them down. Sane speculators never bet against central banks, the center of the entire financial universe: they create money, regulate credit, and often decide whether troubled private banks will live or die. While not almighty, central banks often get what they want, so they affect speculators' sense of the future very powerfully. (Major central banks, that is; the Fed and the Bundesbank are mighty, but the Bank of Mexico is weak and the Bank of Zaïre little more than a joke.) Since financial asset prices are built largely of expectations about the future, stimuli or depressants to those expectations bear very directly on their prices. Optimism boosts prices, and pessimism depresses them.

Relative attractiveness of alternative investments. When interest rates are low or falling, people despair of the earnings on their Treasury bills, bank deposits, or money market funds; they search for juicier profits, and plunge into stocks or long-term bonds, which typically pay higher interest rates than short-term instruments. But when rates are rising, the relative attractiveness of short-term investments rises. If you can earn 7% on a CD, it may not be worth taking the extra risk of holding stocks; but at 2%, the stocks seem much less intimidating.

Valuation. This is a bit more complicated: it depends on the future value of money, one of the elementary concepts of financial analysis. What is the value of $10,000 in 10 years? It's the amount you'd have to set aside today, at current interest rates, to reach that $10,000 in 10 years. If you were guaranteed to earn a 5% interest rate every year for the next 10, you'd hit $10,000 if you made a bank deposit of $6,139, or bought a bond of that value. That $6,139 would grow to $6,446 in a year (the original amount plus 5% interest, $6,768 in the second yearand so on, until year 10, when the $10,000 target would be hit. In financial jargon, the present value (PV) of $10,000 at 5% over 10 years, then, is $6,139. But what would happen if interest rates were to rise to, say, 10%? You'd need to set aside a lot less, because each year's interest earnings would be twice as high - and since you'd be earning interest on interest, the effect is greatly magnified. At 10%, the PV of $10,000 in 10 years is $3,855, well under the PV at 5% (37% less, to be precise). This is illustrated graphically nearby.

How does this affect asset prices? The value of a stock, fundamentally speaking - leaving aside all influences of optimistic or pessimistic psychology - is a function of the profits that its issuer will earn over time, or the dividends it will pay to shareholders out of those profits. (Dividends are generally more stable than profits, but depend ultimately on them, so for the purposes of this exercise, they are pretty well interchangeable. Academics seem to prefer looking at dividends, and Wall Streeters, profits.) In a normal world, those profits or dividends can be assumed to grow with the economy every year. Some years, of course, will be better than others, but over time, it's not unreasonable to assume that the joys of ownership will grow by 510% a year. Take, for example, a coporation that earns $10 in profits for every share of stock outstanding. Assume further that that amount will grow by 7.5% every year for the next 20. What is its stock worth? In theory, its price should be some function of the PV of that future stream of profits, discounted at prevailing interest rates. In this example, the stock that "earns" $10 today, growing 7.5% a year to $39.51 at the end of 20 years, will throw off $433.05 in profits over the 20-year period. At 5% interest rates, the PV of that stream is $240.39; at 10%, $147.43. So even if the future prospects of a corporation remain unchanged, a rise or fall in interest rates greatly changes the arithmetic used to value stocks. And if the change in rates changes one's estimates of future growth prospects - if, say, higher interest rates lead the prospective stockholder to mark down estimates of future profit growth, because of a less friendly economic environment - then these simple arithmetic changes are magnified.

Economic conditions. Stocks rise when investors anticipate an increase in profits and fall when they anticipate a decrease, and profits move with the business cycle, rising in expansions and falling in contractions. I'll have more to say about this in a bit, but on the matter of immediate relevance, higher rates often portend a slump and lower rates a recovery. Consequently, movements in interest rates color investors' estimation of the future course of profits.

With assets other than stocks, the economic environment counts less directly. In a recession, speculators assume that other players will be or feel less flush, making the prospects for unloading an asset - whether it be a Rothko or 1,000 shares of Microsoft - a higher price less friendly. Words of caution are in order here too; no one knows for sure when a recession will hit, so speculators may bet that there will always be some "greater fool" to take a rare baseball card off their hands, or that things are different this time and higher rates won't bring about a recession.

These are some of the reasons why interest rates have such a profound impact on the prices of stocks and other speculative financial assets. And since many of the same techniques used to value stocks are applied to real-world assets as well - like an ongoing business that may be up for sale, or the willingness of a firm to undertake a new project or expand an existing one - rates are a powerful influence on real activity as well, not even considering the effects that changes in interest rates have on the finances of both debtors and creditors.

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