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What are the effects of Declining Interest Rates?

Declining Interest Rates Image

This information was gathered from a recent memo written by Howard Marks as he is describing a changing environment from a period of declining interest rates to that of a rising rate. 

We have not seen a consistent period of rising interest rates since 1980 when Fed chairman Paul Volcker was determined to extinguish inflation that was around 13%. Fed chairman Volcker rose the Federal funds rate to 20% in 1980 to take drastic measure and get inflation under control. As a result of these measures inflation was back down to 3.2% by the end of 1983, 3 years after these steps were taken. Fast forward to what we saw for the next 40 years – a period of steady and consistent declining interest rates. What does a prolong period of declining interest rates have on the economy? Here is what those conditions led to. 

  • They accelerate the growth of the economy by making it cheaper for consumers to buy on credit and for companies to invest in facilities, equipment, and inventory. 
  • They provide a subsidy to borrowers (at the expense of lenders and savers). 
  • They reduce businesses’ cost of capital and thus increase their profitability. 
  • They increase the fair value of assets. As interest rates fall, valuation parameters such as p/e ratios and enterprise values rise, and cap rates on real estate decline. 
  • They reduce the prospective returns investors demand from investments they’re considering, thereby increasing the prices they’ll pay. 
  • By lifting assets prices, they create a wealth effect that makes people feel richer and thus more willing to spend. 
  • Finally, by simultaneously increasing asset values and reducing borrowing costs, they produce a bonanza for those who buy assets using leverage. 

Here is the effect that using leverage can have on rates of return when a buyer uses leverage to purchase assets. 

A buyer analyzes a company and concludes that he can make 10% a year on it and decides to buy it. Then he uses leverage for 75% of the purchase with 25% down payment. He is told his interest rate for borrowing 75% is 8% and his rate of return is 10%. Therefore, he is earning 10% on 75% of the capital which levers up the return on his equity to 16%. If banks compete for the loan, the buyer gets a 7% interest rate instead of 8% making the investment even more profitable – a 19% levered return. 

The interest cost on his floating rate debt declines over time, and when his fixed rate matures he finds he can roll it over at 5% – making a 25% levered return. Is it any wonder that private equity and other types of investments have experienced great success over the last 40 years? 

 

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