One Thing That Powers Everything in Finance

Editor's note: Few forces matter more in investing than interest rates. According to Dr. David "Doc" Eifrig, CEO of our parent company MarketWise, they influence how every asset is priced... and where investors choose to put their money. In this issue, adapted from Doc's Health & Wealth Bulletin e-letter, he explains how changes in rates reshape the market – and why understanding this dynamic is key to navigating what comes next...

According to legendary investor Warren Buffett, "Interest rates are to asset prices like gravity is to the apple. They power everything in the economic universe."

That's no exaggeration.

The value of your stocks, bonds, home, insurance policies, income stream, and more... all depend on the prevailing interest rate of the day.

That's why developing an intuition for how interest rates work is essential to understanding what will happen to your investments. Once you understand how interest rates shape asset prices, you can start to anticipate where money will flow next – and position yourself ahead of it...

Interest Rates Affect Every Asset

When it comes to interest rates causing asset prices to move, what you're really assessing is how interest rates change the way buyers and sellers think about that asset.

This happens in two ways: the time value of money and relative yields.

The time value of money simply means that money today is worth more than in the future. For example, if I offered you $100 today or $100 a year from now, you'd probably prefer the $100 today. That's just human nature. Why wait for the same amount of money?

But if I kept offering you more in the future, I'd eventually hit a price point where you'd prefer the money a year from now. Perhaps you'd like $100 today, but if I offered you $105 in a year, you'd happily wait to earn that extra cash.

And you know what's a good rate to determine the changing value of money over time? The current interest rate.

If you can earn 5% by parking that $100 in a bank account, I'd better offer you at least $105 in the future to compensate you for the interest you "lost" by waiting for the money.

Let's reset our example. Say you "own" a promise to collect $100 a year from now. If you wanted to sell that promise like an asset, you'd have to discount it since it occurs in the future. Perhaps with interest rates around 5%, you could sell it for $95. (If you earn 5% on $95, you end up with $99.75... essentially $100.)

But if interest rates rose to 10%, the price of your asset would fall in value to about $91. That's because if we put the money to work at 10%, that $91 would be worth around $100 in one year.

So rising interest rates lower the present-day value of future money... while falling interest rates raise the present-day value of future money.

And since every financial asset is a claim on future money, interest rates affect the price of every asset.

Treasury Rates Show What Investors Really Value

The second way to think about the prevailing interest rate is by considering your current investment choices.

Oftentimes, the 10-year U.S. Treasury rate can be thought of as the interest rate.

It's backed by the U.S. government and is considered the "risk free" rate. Today, you can park your money there and collect about 4.3% – not too bad.

If you wanted to invest in a corporate bond instead, you'd be taking on more risk. For that reason, corporate bonds must pay more than whatever the 10-year Treasury rate is.

In 2020, when the Treasury rate paid 0.5%, a AAA-rated corporate bond (the highest rating possible) paid about 2%. But with the Treasury yield at 4.3%, AAA-rated corporates now pay about 5.5%.

(And remember, since prices and yields move inversely, for the same bond to pay a higher yield, that means its price fell in the meantime.)

The same relationship holds, though less directly, for equity investments. Greater upside potential and downside risk complicate things, but the principle is still in place.

Imagine you're looking at a real estate investment trust ("REIT") that pays, say, 3%. It looks a lot more valuable when interest rates are at 0.5% than when they're at 4%. Why would you take a lower yield with more risk when you could earn more in a completely safe Treasury bond?

So higher interest rates drive up the yield (and, in turn, drive down the share prices) of income-paying stocks. Folks aren't willing to pay as much for these equity investments when they can do so well with risk-free Treasury securities.

For about a decade, no one cared about this lesson...

After the 2008 financial crisis, the Federal Reserve drove interest rates down to zero to help bolster the economy. It started raising rates again in 2015... but not enough to make much of a difference.

Then, the pandemic-driven recession of 2020 sent rates down again. And the subsequent inflation led the Fed to hike rates rapidly, starting in 2022. You can see how the 10-year Treasury yield soared...

Today, interest rates do matter. They once again power everything in the economic universe.  

We've seen six rate cuts in total since September 2024. But with the war in Iran and its oil supply shock, the Federal Reserve has been worried about inflation again. The central bank likely won't cut rates further if it thinks prices could rise out of control.

Buffett's analogy still holds...

Interest rates are the gravity of the financial system. The mistake most investors make is reacting after the move has already happened.

But if you understand how this "gravity" works... you can position yourself ahead of the shift, instead of chasing it.

In the markets, the biggest gains go to the investors who move before the crowd – not after.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig

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