Interest Rates and Strange Moves

Fundamentals of Market Investing by Adam J. McKee

As we discussed above, the general tendency of stock prices is to go down when interest rates go up.  This is not the case for all stocks, however.  As Jim Cramer’s tagline says, “There is always a bull market somewhere.”  Banks and other financial institutions that make their profits from charging interest can make more money in higher rate environment.  Investors, especially those of the fundamental persuasion, are always looking for anything at all that will signal a profit increase (or decline) before the company can show that profit in its earnings report.  This lets them get in early and enjoy the rise when the company reports good earnings.

These stocks may go up because of higher rates.  If Mr. Market is having a bad day and new rate hike, or an unexpected hike, or a hike that was larger than expected is announced, the market will throw a temper tantrum and prices will fall (and then often rise again within the same day).  Keep in mind that market wide declines will move everything down, even if those stocks are likely to benefit from the catalyst that spooked traders.

When there is a big market selloff and the VIX spikes past 30, traders will likely panic and sell off everything.  The cool-headed investor can use this unexpected sale to put dry powder to work in companies that actually stand to profit from the catalyst.  When FOMC decisions are the catalyst, the only investible changes are unexpected changes.  Investors will have already anticipated what they think will happen (the FOMC is fairly transparent in what they will do), and that expectation is already baked into the price of stocks in the financial sector.

When interest rates rise, the prices of commodities tend to move lower.  When interest rates fall, commodities tend to rise in price.  In a low-interest rate environment, the cost of financing stockpiles is lower than when interest rates are high.  Higher rates also influence storable commodity prices by increasing the incentive for extraction in the short term rather than at some future date.  Consider the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled.  The more capital intensive these activities are, the more likely companies that profit from these activities will need to borrow to sustain operations.  When the cost of capital is cheap, it pays to dig today.  This increases surplus (supply), and price declines follow.

Higher interest rates also nudge speculators to shift out of commodity contracts (high risk), and into treasury bills (no risk).  The laws of supply and demand make sense when considering the price movements of the underlying commodity, but remember that supply and demand also influence the prices of contracts independent of the underlying asset.  Anytime there is a more attractive asset that investors want to move into, the things that they are selling to generate capital to make a move go down in price.  This is a major cause of price movements in stock market “sector rotations,” and the same logic can be applied to all markets.

Higher rates also cause the prices of commodities to decline because high rates cause appreciation in the dollar (or whatever domestic currency we are considering) and so reducing the price of internationally traded commodities in domestic terms (even if the price hasn’t fallen in terms of foreign currency).  Investors must take care to note that the impact of rates on commodity prices also depends on how expensive it is to store the commodity.  In other words, carrying costs must be considered.  Storing stuff costs money, and the more bulky or degradable the stuff being stored, the more it costs.  Diamond miners have very low storage costs if their stockpiles increase, but a farmer with a bumper crop of soybeans has limited storage options and must sell quickly.

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