Vol. 2, No. 24
Vol. 2, No. 24
The link between central bank assets and interest rates. Stocks are slightly overvalued. Moody's upgrades Congo and Belize. Value in a British grocer.
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In today’s issue
Cartoon: Well done, young grasshopper
Ideas arena
Valuabl explains (4 minutes)
Cost of capital (3 minutes)
Global stocktake (3 minutes)—Paid subscribers only
Credit creation, cause and effects (5 minutes)—Paid subscribers only
Debt cycle monitor (2 minutes)—Paid subscribers only
Rank and file (2 minutes)—Paid subscribers only
Investment idea (11 minutes)—Paid subscribers only
"It is often said that men are ruled by their imaginations; but it would be truer to say they are governed by the weakness of their imaginations."
— Walter Bagehot
Cartoon: Well done, young grasshopper
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Top topics from the ideas arena
Valuabl explains: the link between central bank assets and interest rates
The central bank's balance sheet and interest rates are two sides of the same coin. To translate monetary policy, you must understand how the modern banking system works. Here's an explanation in plain English.
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When you send money to a friend, your bank sends it from your account to hers. The numbers in your account go down by the same amount hers goes up.
If you and your friend use the same bank, the transfer is simple: one account to the other. But if you use different banks, your bank will send the money to your mate's bank, which will then pop this money into her account.
But your banker didn't pack up the cash and post it to your friend—they did a digital transfer. Your bank transfers money from their account at the central bank to the other's central bank account. This is called an interbank transaction.
Thousands of these interbank transfers happen every hour. To simplify the process, they do one big transaction at the end of the day instead of as they happen. If two banks owe money to each other, they only transfer the difference between what is owed at the end of the day.
The money in banks' accounts at the central bank is called reserves. Lawmakers make banks keep enough reserves to ensure that the end-of-day settlement can happen smoothly. But if a bank needs more reserves than it has, it can borrow these excess reserves overnight from another bank with too many, so the tab gets paid. The more excess reserves that all banks have, the lower the rate they will charge other banks to borrow them, and vice versa.
These overnight loans are as close to risk-free as it gets—big banks are well-capitalised, the loans are short-term, and the government guarantees most deposits. So, banks compare all other loans to that overnight interbank rate. If a bank can get 3% lending its reserves to other banks, why would they lend on a credit card at 3%? This creates an interest rate floor.
The central bank will mould banks' total excess reserves to control the interest rate. They increase excess reserves to lower the interest rate and reduce them to raise rates. The central bank will trade bonds for bank reserves to do this.
To lower interest rates, the central bank will put more reserves out there by buying bonds from banks and paying them with reserves. More bonds mean a larger balance sheet. But to cut reserves and raise interest rates, the central bank will sell bonds to the banks and erase the reserves it gets in return—reducing the central bank's assets.
“Every banker knows that if he has to prove he is worthy of credit, in fact his credit is gone.”
— Walter Bagehot.
Cost of capital
Interest rates are finance’s most important yet misunderstood prices. Here’s what happened to the cost of money in the past fortnight.
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Stock prices rose last fortnight. The S&P 500, an index of big American companies, climbed 7% to 4,004. Investors added $5trn to global equity markets (see: Global stocktake) as inflation-adjusted interest rates fell. The market has bounced back from its recent lows but is still down 15% in the past year.
I value the S&P 500 at 3,851, which suggests it is 5% overvalued.
The companies in the index earned $1.8trn after tax in the past year. They paid out $506bn in dividends and $1,041bn in buybacks and issued $74bn worth of equity. Analysts reckon their earnings will rise to $1.9trn this year and $2trn next.
Government bond prices rose. Yields, which move the opposite way to prices, dropped again as inflation expectations fell. The yield on a ten-year US Treasury bond, a critical variable analysts use to value financial assets, fell 36 basis points (bp) to 3.8%. Investors expect inflation to average 2.3% over the next decade, down 10bp from the rate they expected last fortnight.
Hence, the real interest rate, the difference between yields and expected inflation, dropped 26bp to 1.4%. These inflation-adjusted rates rose 2.4 percentage points in the past year and are about the highest they’ve been since 2010.
Corporate bond prices also rose. Credit spreads, the extra return creditors demand to lend to businesses instead of the government, dropped 20bp to 1.8%. The spread on these BBB-rated bonds is up 59bp in the past year.
The cost of debt, the annual return lenders expect when lending to these companies, dropped 56bp to 5.5%. Refinancing costs have almost doubled, up 2.7 percentage points, in the past year. Lenders now charge firms about the highest interest rates since 2009. Many firms that came to rely on cheap debt in the past few years won’t survive.
Equity investors are fairly optimistic. The equity risk premium (ERP), the extra return investors demand to buy stocks instead of risk-free bonds, dropped 17bp to 4.9%. They’re now just 32bp higher than where they were a year ago. Similarly, the cost of equity, the total annual return these investors expect, fell 53bp to 8.7%, 2.4 percentage points higher than last year.
Money talks—it just needs an interpreter
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