Friday, January 8, 2016

January 2016 Data Update 2: Interest Rates, Exchange Rates and Currencies

In both corporate finance and valuation, interest rates and exchange rates play a big role, the former because they form the basis for estimating required returns on risky investments, and the latter, since they affect your earnings and cash flows. That said, the biggest mistakes that we make in finance often come from trying to forecast one or both variables, implicitly or explicitly, when making corporate finance or investment decisions. 

Interest Rates
For much of the last year, the focus for US interest rates stayed on the Fed and whether it would  abandon its "low rate" policy. I contested the notion that the Fed sets interest rates in a post on September 4, 2015, leading into a FOMC meeting, and argued that even if the Fed did change its policy, the effect on rates would be muted. The Fed did not act in September but it finally did in December, when it raised the Fed Funds rate for the first time since the 2008 crisis. Given the long and involved lead up to this action, you would have expected treasury rates to jump sharply right after, but they did not. In the graph below, the 3-month treasury bill rate and the 10-year treasury bond rate are plotted by day, through 2015:
Source: Federal Reserve in St. Louis (Download spreadsheet)
There was some action on the treasury bill front, with rates rising from close to zero percent to 0.25% in the weeks around the action (mostly between September and December), before ending the year at 0.21%. It was an uneventful year for treasury bonds, with barely perceptible movements for much of the year and no discernible effect from the Fed's actions; we started the year with a ten-year treasury bond rate of 2.17% and ended the year at 2.27%, still well below historic norms:
Source: Federal Reserve in St. Louis (FRED) (Download spreadsheet)
I know that looking at this graph, you feel the urge to normalize, just as you probably have each year for the last few, replacing today's rates with a longer term average. I have long argued against this practice and I will do so again. I believe that today's low rates across developed markets is not a passing phase or a central bank set anomaly but more a reflection of a low inflation (perhaps even deflation) and low real growth. Updating a data series that I have used before, I compute the intrinsic treasury bond rate as the sum of the inflation rate and real GDP growth rate that year and compare it to the actual treasury bond rate:
Download spreadsheet
The intrinsic ten-year bond rate, if you add the latest estimates for inflation (0.40%) and real GDP growth (2.1% annualized, through 3rd quarter), is 2.50%, close to the treasury bond rate of 2.27% on December 31, 2015. Unless one or the other of these variables changes significantly over the next year, I don't see rates moving back this year, with or without Fed action.

While there was little movement in US treasury rates during the course of the year, there was volatility in the corporate bond market, especially in the last few weeks of the year.
Source: Merrill Lynch Indices (from FRED) (Download spreadsheet)
Corporate default spreads (over the US T.Bond) increased across the board during the course of the year, unusual for a year where the US economy was showing signs of strength, but indicative of both the globalization of the US corporate bond market and the corrosive effects of the commodity price meltdown. In November and December, the lowest rated bonds (CCC and below) saw default spreads widen dramatically, perhaps a precursor to the repricing of risk both in this and the equity markets.
Currencies and Exchange Rates
The world used to be a much simpler place before globalization. Most companies did business in the countries that they were incorporated in and raised their financing (debt and equity) in the local currency. If exchange rates were an issue, they had only a marginal impact on earnings and value and the effects were easily eliminated through hedging. Those days are in the past, as multinationals are now more the rule than the exception, not only spreading their operations around the world, but also raising funding in multiple currencies.  In a post in July 2015, I looked at how corporate financial decisions and valuations are distorted by decision makers mixing and mismatching currencies. As China's markets melt down and threaten to take the rest of the world down with them, and exchange rates are in turmoil, I decided to revisit some of the basic rules of dealing with currencies, using my most recent data update to fill in the blanks.
  1. There is no global risk free rate: While 2.27% is the US dollar risk free rate, it cannot be used as the risk free rate if you are working in Euros, Yen, Yuan or Reais. At the start of each year and again mid-year, I estimate risk free rates in different currencies, starting with the government bond rate in that currency (if available) and then adjusting for any default risk that may be embedded in that bond, using the local currency rating for the country. Thus, to estimate the risk free rate in Chilean pesos on December 31, 2015, I subtract out a default spread of 0.67% for Chile (based on its Moody's local currency rating of Aa3) from the 4.75% at which the ten-year Chilean government bond,  denominated in pesos, was trading to get a risk free rate of 4.08% in Chilean Pesos. I was able to repeat this process for 42 currencies and they are captured in the picture below:
    Spreadsheet with risk free rates
    The weakest links in these estimates are not the default spreads, but the government bond rates, since many government bonds are illiquid and controlled.
  2. Inflation is the core fundamental: In the long term, interest rates in different currencies and exchange rates across them are determined by inflation differentials. In fact, one check of whether the interest rates computed in the last section for different currencies are reasonable is to compare them to inflation in these currencies. For instance, consider the Vietnamese dong, where my estimate of the risk free rate (based on the government bond rate) was 2.06%, but where inflation averaged 10.54% over the last five years. Using the rate on the inflation-indexed treasury bond (0.73% on December 31, 2015) as a measure of the real interest rate (globally), the synthetic risk free rate for Vietnam would be 11.27%, much higher than the computed risk free rate. (This spreadsheet has synthetic risk free rates computed for countries.)
  3. The key to dealing with currencies is to be consistent: In my post on currencies in July 2015, I argued that valuation/corporate financial decisions should be currency invariant; a company that looks expensive, if you value it in US dollars, should not magically become cheap, if you value it in Indian rupees. The reason is simple. If you value a company in Indian rupees instead of US dollars, you will be using a higher discount rate (since the risk free rate in Indian rupees is about 3% higher than the risk free rate in US dollars) but the effect will be offset by the growth rate being higher by 3% as well. For companies with operations and financing in many countries and currencies, you therefore have two choices. The first is to pick a single currency to value the company in and to convert all of the numbers into that currency before doing your valuation; you can value Nestle in Swiss francs, US dollars or Russian Rubles. The second is to value each currency stream separately, using that currency's inflation in both the cash flows and the discount rate, and to add the values of the different streams. That may sound more precise but it is not only a lot more work but may require information at the regional level on investment and cash flows that is not always available.
  4. Exchange rates are momentum driven, but fundamentals ultimately win out: Currencies are momentum driven, allowing traders to make money for extended periods on strategies that build on momentum. However, when momentum shifts in currency markets (either because of a market mood shift or a government intervention), the profits generated from years of momentum trading can be wiped out in a fraction of the period. In my valuations, when I have to forecast exchange rates (to convert cash flows in future periods from one currency to another), I adopt a very simple strategy, using the differential inflation rates between the currencies as my basis for expected currency appreciation or depreciation (purchasing power parity). Thus, if I were required to forecast the US dollar/Indian rupee exchange rate for the next decade in a valuation, I would build in an expected depreciation in the rupee of about 3% (the same inflation differential between the Indian rupee and the US dollar that I used in the risk free rate computation). Not only does it keep my valuations internally consistent but it comes with two bonuses. The first is that my inflation mistakes cancel out; thus, if the expected inflation in India turns out to be 6% higher than the US inflation rate, instead of 3%, both my cash flows and my discount rates will be understated and the effects will offset. The second is that I save myself the aggravation of having to listen to currency experts, whose expertise seems to lie not in forecasting in the future but in providing elaborate rationales for past forecasting errors.
Bottom line
This has been the worst opening few days for equity markets in the United States in history, and the damage has been greater in many emerging markets. The US dollar is stronger, emerging market currencies are weaker and interest rates are on the move. The macroeconomic soothsayers will be out in full force, with predictions aplenty about where interest rates and exchange rates will be going this year. Much as you will tempted to alter your asset allocation mixes and investment strategies, based on their forecasts, my advice is that you chart your own course. I plan to take the karmic route for macro variables, accepting that change is the only constant and completely out of my control. While that strategy may do little to protect my portfolio, it does wonders for my psyche.

  1. US treasury bond rates (actual and intrinsic) - 1960-2015
  2. US treasury bond and bill rates (Daily for 2015)
  3. US corporate bond yield spreads (Daily for 2015)
  4. Risk free rates by Currency (January 1, 2016)
  5. Synthetic Risk free rates by Currency (January 1, 2016)
Past Blog Posts on Interest Rates and Currencies


Steve said...

Prof D:
Since most of the companies most of us are likely to invest in are listed on US stock exchanges including multinational and foreign companies who file 10K and 6F reports, respectively, with reported results in US dollars, it seems to me that the otherwise issue of having to deal with multiple currencies for projections is done for us and all we really have to is adjust WACC to take in to account country risk for where revenues are generated. Am i correct in this thinking?

Aswath Damodaran said...

I am sorry but most companies are not listed on the US exchanges. Only the large market cap companies have multiple listings. Of the 33,000 non-US companies in my same more than 95% only have local listings.

John said...

So Prof. should it be used risk free rate(2.06%) or synthetic risk free rate of Vietnam (11.27%) ?

Anonymous said...

I think what the person is saying is that many people look to invest in companies listed on US exchanges and therefore for those companies the work is done since they report in US $; and while many are multinational, there are exceptions. One example would be Shopify, a small growth company in Canada. Is Bidu a multinational? It lists on US exchange. He was not saying anything about the 33,000 others you mention.

Anonymous said...

Thanks for the very original and insightful post! How to understand the risk free risk = 10 year treasure bond - default spread, the "-"?

Hugo Francisco Caycedo Godoy said...

Regarding the question of what risk free rate we should use in the case of Vietnam, i found these facts:

Central Bank monetary policies have little effect on bond rates, instead, inflation and growth are the main drivers of their value. He added up both and the results are quite similar to the actual bond rates.

He calculated the risk free rate for many countries (i am very thankful with professor Damodaran) but he warns us about the fact that in many countries bond prices and their liquidity are controlled by the government (which means that some of those numbers do not come from a true market and hence are not reliable).

With these things in mind: what can we think about a risk free rate from a developing and non democratic country that is lower that the US risk free rate?, what about the high inflation in Vietnam?. Note that if we compare the synthetic risk free rates with the risk free rates, in most of the cases both are relatively close ( 1 to 3 percentual points of difference) but in the case of vietnam the difference is near to 10 percent.

Therefore, and taking in account the high inflation and the high growth of this economy, i think the risk free rate(2.06%) is underestimated.