The Fed “Put” - What is it Worth?
Updated: Jun 9, 2019
This week the market shook off the trade war fears with the help of some accommodative language from Federal Reserve officials. Non-Farm payrolls came in lower than expected and that lack of job creation further reinforced hopes that the Fed will cut rates this year. It was one of those cases when bad news (fewer jobs) was good news; that defies common sense but let’s leave that discussion for another time.
The Federal Reserve targets the fed funds rate and that is their lever to move interest rates up and down. It is a bit more complex than that but that is the gist. If you’d like to see how the market thinks of the probability that the Fed will raise or lower rates in the future, the CME provides this nice tool to investigate.
So, I wondered, if I took a “typical” stock valuation method, like discounted cash flow, and applied different yield levels, how would that affect that stock valuation? And, by doing so, could I get an idea of just how much “juice” the Fed could add to the typical stock? So I did that. The plot is below.
I tried this across about 30 different stocks. The results vary a bit, mainly in the convexity (bend) of the curve. For argument's sake, the results were roughly the same, and I thought one plot was more illustrative than many.
The current weighted average cost of capital for this stock was 6.4%, which was a bit high compared to average. This was a higher beta name. I applied a range of treasury curves with the lowest at 50 basis points at the 2-year yield point. You can see that at that lowest range, the stock valuation moves up from 130 to 140 or 7.7%. That’s not a lot. You can also see that at the highest range it falls 23%, which starts to become meaningful.
From a pure math perspective, lowering rates only adds, optimistically, maybe a 10% gain to the stock market from here.
So why then do we get these wild swings when Fed officials speak in dovish (ie indicating they would lower rates) tone? Mainly it is psychological. It’s nice to know someone has your back. It also explains why last fall Mr Market got so nerved up; not only was the Fed seemingly going to raise rates, we had tariff concerns (round 1), growth concerns, and a looming government shutdown. The downside of higher rates is larger than the upside of lower rates, as you can see in the plot.
The upside to lower rates is probably also muted by the fact that the yield curve is reasonably flat right now, meaning most rates along the term structure are close to each other. So even if the Fed lowered rates from here, longer-term yields, which more greatly influence the discounting that values stocks, probably wouldn’t move down much. Aside from lowering rates, the greatest benefit the Mr Market can get from the Fed right now is stability.
Hope that helps.