Rising interest rates, especially in the developed world, require a fundamental shift back to the pre-Global Financial Crisis era. How must they adapt?
Interest rates, as Warren Buffett aptly put it, are akin to gravity in the world of finance – they power everything in the economic universe. Just as gravity influences every object’s movement, interest rates play a pivotal role in shaping economic decisions and outcomes. For the past 15 years, the developed world has experienced a unique financial phenomenon: near-zero short-term interest rates.
During this period, many managers became accustomed to an environment where the time value of money was virtually ignored, neglecting a fundamental principle of financial analysis. However, as short-term interest rates have now surged beyond 5%, managers – both seasoned and newcomers – find themselves in unfamiliar territory posing a significant challenge for those who have neglected the importance of the time value of money and the cost of capital in their decision-making processes.
The Sudden Return of Gravity
Imagine again a hypothetical planet where gravity is suddenly switched off for 15 years. Inhabitants become adept at effortlessly floating through the air, mastering the art of aerial navigation. But when gravity is abruptly reinstated, they must readapt to life on solid ground and reacquire basic locomotive skills like walking. This analogy serves as the perfect metaphor for the financial world’s experience with near-zero interest rates. For over a decade and a half, short-term interest rates in the U.S. remained near zero, leading to a situation where concepts like hurdle rates and discounted cash flows seemed almost obsolete.
The origins of this financial anomaly trace back to the Global Financial Crisis of 2008. In response to the economic turmoil, the U.S. Federal Reserve introduced the “zero interest rate policy” (ZIRP). This policy aimed to stimulate economic recovery by drastically reducing the federal funds rate. Even as the economy rebounded, ZIRP persisted and was reintroduced during the Covid-19 pandemic. Consequently, short-term interest rates in the U.S. remained near zero from 2008 to 2016 and once again throughout much of 2020 and 2021, with only a brief deviation above 2% in 2018 and 2019.
Fast forward to 2023, and the ZIRP era is officially over. The benchmark Fed Funds rate has surpassed 5.25%, while five-, ten-, and thirty-year U.S. Treasuries offer yields near 5%, reaching levels not seen in a considerable time. This shift from nearly-zero interest rates to a more typical interest rate environment is nothing short of unprecedented. Although the term “unprecedented” has been frequently used in recent years, it is vital for managers to recognise the magnitude of this departure from the norm.
An Illustration: The Subway Token Question
Consider a thought experiment often posed in strategy consulting interviews: You face a scenario where you must commute by train to work every weekday for the next five years. Each trip requires a token, which currently costs $1. Tomorrow, the price will rise to $1.20 and remain there for the next five years. You have the option to buy as many tokens as you want at the current $1 price, and reselling the tokens is not permitted. The question is: How many tokens should you purchase at today’s $1 price before the permanent price increase to $1.20?
While some may instinctively want to stock up on tokens, the essential question is: What else can you do with your money? In this thought experiment, candidates are given an alternative option – investing the money in a bank savings account with an annualised interest rate of 10%, free from taxes, transaction costs, bank failures, and inflation.
The answer becomes clear when considering the time value of money: One should purchase only two years’ worth of tokens, as money invested in the bank will grow over time, exceeding the new token price. This simple example demonstrates the importance of understanding the time value of money, a fundamental concept underlying finance principles like net present value (NPV) and discounted cash flow (DCF).
Despite their proficiency in manipulating complex spreadsheets for precise NPV and DCF calculations, many individuals still struggle to apply these principles in everyday scenarios. This challenge is particularly pronounced among those who entered the workforce after 2008, during the ZIRP era, when interest-bearing bank accounts were virtually non-existent. In such a context, buying all available tokens or pursuing all possible projects and investments may have seemed logical.
However, as interest rates return to more typical levels, the fundamental understanding of the time value of money becomes paramount. Every strategic or financial decision involving multi-year cash flows must be re-evaluated with updated assumptions regarding the cost of capital. The substantial increase in the cost of capital compared to the past will likely reveal that immediate actions to enhance profitability, cash flow, and capital efficiency hold more value than long-term growth-oriented investments.
While addressing the mathematical aspect of financial analysis is crucial, it is equally important to adjust the entrenched managerial mindsets that evolved during the 15 years of near-zero interest rates. The era of “moonshot” thinking, which thrived in the low interest rate environment, may need to give way to a more traditional, value-oriented approach to tackle the challenges that lie ahead.
Managers must now swiftly adapt to the changing financial landscape, just as individuals relearn to walk when gravity returns. The sudden shift from near-zero interest rates to a more typical environment underscores the significance of understanding the time value of money and the cost of capital in making informed financial decisions. Navigating this new paradigm requires not only a shift in mindset but also a commitment to relearn the fundamental principles that have long been dormant in the world of finance.