If you're losing sleep ahead of next week's pivotal U.S. Federal Reserve meeting, rest easy.
The obsessive attention being paid to the meeting by a mini-industry of pundits and analysts speaks to investors' belief that the Fed has a near-omnipotent ability to support stock markets with low interest rates.
However, that faith is largely based on mythology, according to Aswath Damodaran, a professor of finance at New York University and widely cited expert on corporate valuation.
He says the Fed doesn't set interest rates – at least not the ones that matter to the stock market. Despite what many people think, there is little evidence that low rates have been responsible for stocks' big gains in recent years, he says.
His skepticism is echoed by other market observers, who say the attention being lavished on the Fed announcement is overdone. While a decision by the world's most powerful central bank to tighten rates for the first time since 2006 would be noteworthy, any increase would probably amount to 25 basis points or so and would hardly be enough to disrupt investors' value calculations. (A basis point is one hundredth of a percentage point.)
"I don't think the Fed will move this time, but even if it does, a 25-basis-point hike by itself isn't going to do much," says Jim Giles, chief investment officer at Foresters, a Toronto-based fraternal benefits organization with more than $25-billion in assets under management.
"The Fed's decision has a certain entertainment value, but there's nothing actionable that comes out of it," agrees Tim McElvaine, president of McElvaine Investment Management Ltd. in Victoria. "It doesn't really affect my estimate of a stock's long-term value."
In theory, higher rates threaten stock prices because more generous bond yields would increase the attractiveness of fixed-income investments and make them a more attractive alternative to shares. Higher rates would also boost the cost of borrowing money, which would cut into companies' profits and possibly undermine their stock prices.
But Prof. Damodaran argues in recent blog posts that most investors overestimate the power of the Fed to affect interest rates. The central bank directly controls only the Fed funds rate at which commercial banks lend each other reserves overnight. There may be a tenuous connection between that rate and other short-term rates, but the linkage fades as the discussion moves on to the key long-term rates that determine investing decisions.
The most important long-term rates aren't set by the Fed. Rather, they reflect the state of the economy, Prof. Damodaran asserts. In fact, the sum of only two factors – expected inflation and expected economic growth – closely predicts the 10-year government bond rate.
So if it's those two fundamentals that determine interest rates, why is so much attention around the world paid to the Fed's musings? "Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies," he writes. "Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise [them by dictat]. If only."
Despite Prof. Damodaran's logic, many investors are convinced that the stock-market boom of the past few years was driven by low interest rates, particularly by strategies such as "quantitative easing" in which the Fed bought huge amounts of bonds in an attempt to lower rates. The natural worry is that the gains will evaporate if rates begin rising again.
But Prof. Damodaran argues that the anxiety is misplaced. Low rates imply slow economic growth, so any beneficial effect from bargain-basement rates in recent years would have been offset by worries about the stagnant outlook. If the Fed does boost rates next week, it would be signalling that it is confident of a stronger economy. That would be good for stocks, everything else being equal.
To be sure, the professor sees risks on the horizon. "The primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return [to investors] in the last few years, combined with a capacity to grow earnings over the same period," he writes.
The torrent of cash may begin to ebb as the high U.S. dollar and weakness in China cut into profits and companies slow down the amounts they are returning to investors. But that will occur no matter where interest rates sit.
For now, Prof. Damodaran hopes that investors will get over their "unhealthy obsession" with the Fed's "interest rate magic show."
He is hoping for a rate increase and predicts that the initial reaction will be negative, but he believes a move away from near-zero rates would ultimately be good as it would allow investors to move on to more realistic concerns about economic growth and earnings.
Ian McGugan