Background of this article
Previously, to help general readers and investors more easily understand the relationship between the Federal Reserve’s interest rate policy and stock prices, I published two posts on my blog: “Why do stock prices automatically rise with inflation?” and “Will Fed rate cut gurantee stock market rise?” I’ve received some responses in recent years.
While the previous post was relatively concise and easy to understand, this post will further explain the relationship between the Federal Reserve’s interest rate policy, stock prices, and government bond yields in greater depth, to help you understand why stock rise as Fed cuts rates?
Rates and Treasury Yields Positively Correlated
Central bank interest rates and government bond yields are highly positively correlated. Their interaction reflects market funding costs and expectations for the overall economy. When a central bank raises its benchmark interest rate, government bond yields usually follow suit; however, government bond yields are determined by bond market prices, making the two inversely related.
Positive Linkage Between Benchmark Interest Rates and Government Bond Yields Impact of Central Bank Policy: Benchmark interest rates (such as the US Federal Funds Rate) are the basis for all interest rates. When central banks raise interest rates, bank borrowing costs increase, the risk-free interest rate rises, and the issuance rate and market trading yield of government bonds also rise accordingly. When deposit or short-term bill rates are higher, market funds flow to high-yield assets, prompting investors to demand higher returns for holding government bonds, thus pushing up government bond yields.
Mary Buffett’s Explanation
Mary Buffett used two examples in her book The New Tao of Warren Buffett to illustrate this. I believe her explanation is very clear, and I quote excerpts below:
Company Value Reflects Market Interest Rates
Suppose Company A consistently generates $10 million in earnings annually. In a world with a 10% interest rate, we must invest $100 million in bonds with a 10% interest rate to earn $10 million annually. This means that at a 10% interest rate, Company A’s market value is $100 million. ($100 million × 10% = $10 million)
Now suppose the interest rate drops to 2%. We must invest $500 million in bonds with a 2% interest rate to earn $10 million annually. ($500 million x 2% = $10 million) This means that Company A, which generates $10 million in annual income at a 2% interest rate, is currently worth $500 million in the market.
DCF’s discount rate must reflect rates
The same inverse relationship applies to discounting a company’s future cash flows to their present value: the higher the discount rate, the lower the present value; the lower the discount rate, the higher the present value. For example, earning $10 million annually for the next ten years, with a discount rate of 10%, yields a present value of $61.3 million. However, if the discount rate is 2%, the same cash flow has a present value of $89.4 million.
If interest rates fall, the relative value of a company’s future earnings will increase, and the stock price will eventually rise accordingly. Conversely, if interest rates rise, the relative value of a company’s future earnings will decrease, and the stock price will eventually fall accordingly.
Note: For information on discounted cash flow (DCF), please refer to my previous post of “DCF (Discounted Cash Flow) Calculator“
Stock valuation is closely related to rates
Apple Stock and Treasury Bonds
For Buffett, the valuation of all investments is closely related to interest rates. If you own one share of Apple stock, and it earns $6.43 per share in 2023, you would need to invest $128 ($=6.43/0.05) in government bonds with a 5% interest rate to earn the same $6.43. However, if the government bond interest rate is only 1%, you would need to invest $643 in government bonds with a 1% interest rate to achieve the same $6.43 return.
Therefore, when interest rates fall, stock prices “tend” to rise; and when interest rates rise, stock prices “tend” to fall.
Apple overvalued as treasury yields raised
Why look at government bonds? Because if they are bonds issued by the U.S. Treasury, the market will perceive them as having no default risk. In 2024, the yield on 10-year U.S. Treasury bonds was 4.3%. Based on this, Apple’s earnings per share of $6.43 were estimated to have a relative value of $149 ($6.43/0.043). Apple’s stock price reached an all-time high of $225 in 2024, 66% higher than this relative value of $149 per share.
Buffett’s Reaction
Buffett’s reaction to this perceived overvaluation was to begin selling his Apple stock. Even the best companies can be overvalued, and Buffett typically reduces his holdings in such cases.
Closing words
In the long run, one of the most significant variables affecting valuation is clearly interest rates. If interest rates are destined to remain very low… this will make any income stream generated by an investment more valuable.
In a Q&A session at Berkshire Hathaway’s 2015 shareholder meeting, Buffett stated, “When the yield on government bonds is only 1%, the value of corporate earnings is obviously much higher than when the yield on government bonds is 5%.”
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