Years of Zero Interest Rates and Implications for Stock Prices

US Federal Reserve Chairman James Powell has said interest rates are likely to stay low for years as the economy fights its way back from the coronavirus pandemic.

For decades, the goal of US Federal Reserve was to control inflation. Inflation control has now been de-emphasized, the main goal is now maximizing employment. This is a huge shift. The US Federal Reserve is very powerful and now the Federal Reserve is pushing for full employment and using years of zero interest rates as a tool.

Don’t fight the Fed

There has been fundamental investment wisdom which “Don’t fight the fed”. You are supposed to line up your investments with Federal Reserve Monetary policy. Buy stocks when interest rates are low and avoid stocks when interest rates are high.

There is and has been an inverse relationship between the stock market’s valuation multiples and interest rates. Ten-year treasury rates have fallen to 0.72%. The central bank now will allow inflation to float above the Fed’s 2% target for a period of time. The Fed no longer will hike rates in order to head off inflation that historically had come with lower unemployment rates.

There will be a zero-interest-rate policy and open-ended quantitative easing (QE) for the next five years.

The projections are that the ten-year treasury interest rate will stay around 0.6 to 1.0% for five years or longer.

Many finance papers and financial sites have a regression analysis of the inverse correlation between interest rates and the price-earnings ratio of the SP500 stock index.

At Financial Wisdom Forum, there are multiple online calculators for different fair price-earnings multiples based upon the ten-year bond interest rate.

The very low-interest rates imply a fair price earnings multiple of 150 to 440. Even if the ten-year interest rates were assumed to be 1.5% then the fair price-earnings multiple is 87 to 107. The lower number is for a formula of a multiple of the average ten-year earnings multiple of the price.

The SP500 has only had the PE Ratio stay above 30 from 1998 to about 2003.

Japan’s Zero Interest Rates and Japan’s PE Ratio

Japan has had zero interest rates for over 20 years. Japan has not had consistent ultra-high PE ratios after their crash. They did have PE ratios over 60 for two extended periods from 1987-1991 and from 2003 to 2008.

New Zero Interest Rate Territory for the USA

The ten year treasury briefly was below 2% before 2019. It happened in 2016 and 2012. It got as low as 1.46% in 2016.

The difference for the US situation and the Japan situation is the zero interest rate situation is now completely global. Japan, Europe and now the USA all have zero interest rates.

China’s ten-year interest rate bonds are at 3.1% and were 2.5% in April during the worst of the Pandemic financial dip.

This is combined with quantitive easing. Quantitive easing is when the central bank purchases longer-term securities from the open market in order to increase the money supply.

Constantly adding trillions to the money supply. No return from bonds. Stocks the only major option for returns. There is still gold, cryptocurrency and real estate.

The inflation statistics will report that there is no inflation but how much should you believe those reported statistics?

Will the old formulas (1970-2020) still maintain the inverse relationship?
Will the old formulas apply in the sub-1.5% interest rate zone?

Multiple years of an index PE ratio at 60 is possible. Nothing is certain, but the Federal Reserve is giving a guarantee of near-zero interest rates for years.

If you believe that asset prices will go down, then you are saying that zero interest rates and trillions in quantitive easing money printing will not drive prices up. Asset prices mainly refers to stocks and real estate.

SOURCES- Financial Wisdom Forum, CNBC
Written By Brian Wang,