The almighty interest rate

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The repo rate, asset prices, and immortality.

PORT ELIZABETH - It is common knowledge that money has a time value with money now being worth more than the same amount of money in the future. For example, any rational market participant would rather have a R1m right now than in a 100 years time...because the chances are good that they'll be dead in a 100 years time.

So, in other words, the time value of money is simply a function of our mortality.

The further in the future we look the greater the risk attached to the actual delivery of money, hence the greater the amount of money necessary to compensate for this risk. This increase in the future nominal amount of money is the discount rate and is intrinsically tied into the market interest rates once it has been adjusted for specific risk.

For simplicity sake, let's call this the "market interest rate" or "market rate" for short (and that this rate excludes inflation).

If there is an asset that generates a risk-free return of R1 per annum for the rest of eternity, the value of this asset is simply the present value of its perpetuity cash flows or "R1 / Market Rate". If the market rate was 10% then the asset value would be R10. The logic for this valuation is that if you bought and held the asset for R10 or stuck your R10 in the bank earnings a risk-free 10% interest on the balance you would yield the same return (ie, R1 per annum). This is only true of the asset as its return is risk-free.

This over-simplification serves as a good example of how asset prices and interest rates are connected and this connection holds true across all asset classes, all markets and all economies.

In the above example, if the market rate jumped to 11% and as the asset's payments are fixed (maybe it's a bond or gilt) at R1 per annum, then the asset's value should change to align its yield with that of the market, ie, it would now be worth R1/11% or R9.09. This would happen naturally as demand for the asset dropped, money flowed into the better yielding 11% bank account and the market price slumped down until the two asset's yield was the same as the bank account.

In our local economy the "risk-free" rate is considered to be the repo rate set by the Reserve Bank and it currently stands at 7%. I am a firm believer that in the short term the market rate fluctuates due to numerous social, political and economic factors. Despite this, in the long term the market rate should follow a strong trend, especially in a developing country where (long-term) systematic risk should (theoretically) be dropping, market depth and breadth expanding, and liquidity increasing the long-term trend of the market rate should be down.

The flipside means that asset prices should also be rising to adjust their yields to be in line with the market rate's yield.

Below is graph of the Bank's repo rate since 1999 and a linear trend line showing the long-term drop in this rate:

It is fairly obvious that our local repo rate has been trending down since 1999, but what needs to be realised is that this repo rate is a nominal rate and includes inflation. The Bank has stated that it operates within an inflation targeting framework, thus if inflation rises then the Bank will raise the repo rate to counter it.

Below shows the repo rate, CPI (or a measure of inflation), the real market rate, and the linear trend lines:

So, stripping out inflation, the real market rate seems to be declining as well. While the repo rate has jumped from a trough in 2004 (blue line) to a recent high in 2008 due to the excess liquidity in the global economy pushing inflation upwards (red line), the real market rate has actually continued to drop during this period (the green linear trend line following the green line).

The implications are simple: (real) asset prices should be rising and (real) yields dropping to align the to the market rate. A further implication is that (perhaps contrary to our local pessimistic perceptions) our systematic risk is dropping relative to the rest of the world. This last point can perhaps be illustrated by our recently strong currency versus the currencies and troubles in the 1^st world.

It is really interesting to note that, per my calculations, the current real interest rate for 2009 was a negative 0.1% or that the average CPI rate outstripped the repo rate. Thus, if you were a bank and could borrow at the repo rate from the Reserve Bank you would theoretically be being paid to borrow...

There is an interesting theory I have regarding the phenomenon of long-term dropping market rates (as, in the long-run this is a global phenomenon): medical technology. Quite simply, medical technology is helping us live longer and increasing our expected lives, thus lowering the "mortality" risk regarding collecting a future return.

For example, say 200 years ago the average life expectancy was 40 years while today it is 85 years. If I offered R1m to a man 200 years ago on the basis that he got it when he turned 50 years old he would demand a much higher interest rate to compensate for the risk that he wouldn't live till then...or he'd just refuse it and require a small (present value, hence larger interest rate) payment now.

The average modern man would probably live till then, thus would require a lower risk-adjusted return.

Hence, global market rates are trending down over the centuries.

(I would love to test this hypothesis, but don't have access to sufficient data. If you have access to this data I would greatly appreciate you dropping me a mail.)

I hope I haven't lost you with the latest sci-fi-like example, but it is an interesting thought contemplating how medical technology extending our lives could be tied into lower market rates.

Also, here's a mind-bender: imagine we advance to a stage where medical technology can keep us alive infinitely ie, we're immortal. If we have all the time in the world to realise an investment...what then would happen to market rates? The entire monetary economy would then be turned on its head...

There is no concrete conclusion to these collections of thoughts, but they do pose a number of interesting points. I am interested in your comments to some of the points I've raised:

Do you think South Africa's long-term systematic risk is dropping or is it just because the rest of the post-subprime world became relatively riskier?
Could the negative real interest rates have helped prop up our local banking sector during the volatile credit crisis?
How are medical technology improvements changing financial markets and market rates?
What would happen to our financial markets, asset prices and the economy as we know it if we all woke up tomorrow immortal?

Alternatively, tweet your thoughts to me here.

*Keith McLachlan is the founder of SmallCaps.co.za, which provides private research on the under covered small cap portion of our market, and apologises for this long-winded article (but sincerely hopes that it at least provoke one new thought).

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