Monetary Policy and Risk Appetite

Interest Rates, Liquidity, and Risk Appetite

Renown investor Stanley Druckenmiller has said “earnings don’t move markets, it’s the Fed… focus on central banks… and focus on the movement of liquidity”. With that in mind, let’s consider how the fed uses its tools to affect liquidity and thereby risk appetite.

Raising/Lowering interest rates, which primarily affects the demand function of the economy/market (inflecting it upwards). Whether it’s an individual’s Schwab account or decisions made at Exxon Mobile, the decision to make an investment is based on whether such investment meets specific risk and return parameters (like a hurdle rate). A hurdle rate is often a function of the Fed Funds Rate, often called the risk-free rate, and risk premiums (to keep things simple we will just work against the risk-free rate). Each increase/decrease in the risk-free rate changes the required return on a dollar of risk. Consider the following:

• An investor has $10mm and can invest risk-free and receive 5% per annum (“p.a.”), or purchase an income producing asset which, for the sake of argument, has a 50% chance of returning 11% p.a. and a 50% chance of returning 0.50% p.a. The expected return of the investment is greater than 5% (the risk-free rate; keep in mind that we are using the risk-free rate and in the real-world additional premiums are added to the risk-free rate to achieve a yield hurdle), and so the decision will come down to risk appetite for upside versus the 5% risk-free return.

• Now consider if an investor has $10mm and can invest in that same risky asset or invest risk-free for 0.50% per annum. The risky asset is a no-brainer in this second scenario. This is an example of moving out on the risk curve. In fact with rates at 0.50%, we likely would not consider assets that are going to return 5-7.5% per annum. Rather, investors begin looking towards the promise of 5-10x returns in a number of years.

In the simplest of terms, moving the risk-free rate up or down moves where investors are on the risk curve by affecting the discounted cash flow formula (below). All cash flows are discounted by the hurdle rate in each period. So, if that hurdle rate goes to ~0%, cash flows ten years in the future are worth just as much as cash today. And, when the hurdle rate moves to 5%, cash flows in ten years are worth very little today:

Jawboning — anyone following the markets over the last year has seen financial conditions ease and tighten as Fed Governors (or Chair Powell) discuss what course they expect interest rate policy to take in the future. This is known as “jawboning”, and is basically an extension of the Fed’s first tool. With the rise of jawboning, we have seen financial markets respond quicker to changes in Fed policy. Not surprisingly, this is because market participants feel they have a better understanding of what the Fed is going to do in the future and, so, participants are able to price in future interest rate changes quicker.

Quantitative Easing (“QE”) and Quantitative Tightening (“QT”) — this is the newest tool in the tool-kit, and we have basically only seen one side since the Great Recession. Think about easing as expanding the Fed’s balance sheet, and tightening as reducing the size of the Fed’s balance sheet (there are more precise definitions revolving around credit conditions that I think are too advanced for this post). The below graph shows the size of the Fed’s Balance Sheet since 2003.

Why do we care about the size of the Fed’s Balance Sheet? See below.

There is a high positive correlation between the size of the Fed’s Balance Sheet and the direction of the market.

Thanks for reading!

Regards,

SimpliFinance