Finally! What Fed Rate Cuts Mean for Tech Valuations

Practical Summary:

• The Fed cut rates last month by a larger-than-expected 0.5%.
• Since early 2020, lower interest rates and higher tech valuations have been nearly perfectly correlated. This article reviews this relationship and its mathematical justification.
• Longer-term rates really affect valuations, and Fed cuts to short-term rates it doesn’t necessarily mean lower longer rates.
• In fact, the Fed might have just made things worse for longer rates by prematurely cutting rates sharply while the economy is growing and labor markets are still tight.

The Federal Reserve Board finally cut interest rates last month. This represents the first rate cut since the start of the COVID-19 pandemic in March 2020 and might be the most anticipated rate cut of all time. The US bond markets had been pricing in multiple rate cuts as early as September 2023, only to be surprised and disappointed over the next 12 months.

At their meeting on September 18, the Fed cut what’s known as its “effective Federal Funds rate” from a range of 5.25-5.50% to a range of 4.75-5.00%. There was a little debate on if this cut would be 25 bps or 50 bps, but the Fed decided to be a little more aggressive than the market expected.

In this post, I explore what exactly happened last month and what this means now for tech valuations.  

How (Exactly) Does the Fed Manage Interest Rates?

Moves by the Fed are heavily covered by the media, but most tech investors don’t really understand what the Fed is or how it controls interest rates.  

The Federal Reserve Bank is the central bank of the United States, responsible for the country’s monetary policy and financial system. The Fed isn’t a true government institution; it is not funded by tax dollars and its decisions do not have to be approved by the President or either House of Congress. The Fed was created in 1913 by the Federal Reserve Act of 1913, which outline the purpose and powers of the Fed.

Among the Fed’s responsibilities are (1) the exclusive management of the nation’s currency, the US dollar, and (2) promoting the soundness of the American banking system.

One of the roles of the Fed is to provide funds to banks that need to finance their daily operations, so that the banking system has sufficient liquidity to function. All federally chartered banks operating in the US that take consumer deposits and issue loans require approval by the Fed. These banks must meet certain reserve requirements, rules that force banks to hold a minimum amount of funds in “liquid assets” such as cash in their vaults or balances at their central bank. The amount of reserves that a bank must hold with the Fed depends on what it does with their customer deposits. If the bank uses deposits to hold high-quality, riskless assets (such as Treasuries), they don’t have to post much in the way of reserves. But as they choose to lend that money out – say, by writing (relatively safe) home mortgages secured by real estate or by financing (risky) startups – they will face stiffer and stiffer reserve requirements. The more risk they take, the higher the reserve needed.

A bank can go to the Fed and borrow money if it needs it to maintain adequate reserves. But the Fed doesn’t provide this money for free. It charges an interest rate, known as the discount rate, to the borrowing bank.  The discount rate is the interest rate charged by the Fed for loans it makes through its discount window. Today, it is set at 5.00% – that rate was reduced by 50 bps on September 18.

The other more important rate controlled by the Fed is the effective Federal Funds rate, often referred to as the “overnight rate,” which is the rate at which banks can borrow from each other. At the end of every day, some banks will have more cash than strictly required by the Fed’s reserve requirements and other banks will have less. Whether a bank is over or under the reserve requirement depends on how much they collected that day in collections and deposits and how much they put out in loans. If a bank has too much cash, they will seek to invest their extra dollars in an overnight market known the repo market, or simply put the money with the Fed. If they have too little, they must borrow either from the Fed directly or, more frequently, from other banks who have money to lend, or from other investors (such as corporations, insurance companies, or governments).

The Fed can control these short-term overnight rates in several ways. The Fed’s Open Market Committee (FOMC) uses tools like “open market operations” (i.e., the buying and selling of Treasury securities) to influence the actual rate that banks charge each other, which is called the effective federal funds rate. The FOMC can add money to the financial system to lower the rate or take money out to increase it.

One way they do that is by setting interest on the reserve balances held by banks at the Fed. This interest on the reserve balances (IORB) allows banks to earn an interest on excess cash, usually acting as a floor on the overnight rate. Another rate that the Fed controls is the overnight reverse repo (ON RRP) facility offering rate. The overnight reverse repurchase facility, known on Wall Street as reverse repo, enables large financial firms such as money market funds to briefly swap extra cash for high-quality securities on the central bank’s balance sheet and pocket some interest. This rate also greatly influences the EFFR, the rate at which banks will lend.

As the Fed lowers interest rate for short-term and overnight investments and increases overall liquidity, other interest rates in the economy – from corporate lending rates to home mortgages – typically move down as well, though usually not by the same amount or at the same time. 

What Happened on September 18

As part of its job, the Fed is supposed to use its tools for managing monetary policy (e.g., setting bank overnight rates and managing the supply of money) to achieve a “dual mandate” of pursuing the economic goals of maximum employment and price stability. These goals were described by Congress and given to the Fed in 1977 in an amendment to the Federal Reserve Act.^[1] Since 2012, under then-Fed Chair Ben Bernanke, the Fed has made explicit its “price stability” mandate by setting an inflation target of 2%.

Between about March 2021 and most of 2023, US consumer inflation jumped to 40-year highs as a result of massive and unprecedented government actions in response to the COVID-19 pandemic. These policies included an unprecedented monetary stimulus in the form of open market actions and bond purchases designed to ensure financial market liquidity and to lower interest rates to record lows of just 0.25% (actions known as quantitative easing. But when combined with a massive federal deficit that increased spending on goods and services, it created the spike in inflation.^[2]

The broadly watched Consumer Price Index – Urban measure of inflation peaked at over 9% in the middle of 2022. Some economists have pointed out that true inflation that accounts for the cost of money (i.e., higher interest costs on mortgages and debt) was much higher, peaking at over 18%. 

Beginning in the middle of 2022, the Fed began to reverse course and engaged in “quantitative tightening” to reduce the money supply, raise interest rates, and tame inflation. From March 2022 to July 2023, the Fed raised it overnight rate 11 times, from a range of 0.25-0.50% to a range of 5.25-5.50%. 

Inflation has remained sticky since 2023 and only recently has subsided enough and come within shooting distance of the Fed’s inflation target, to allow the central bank to consider lowering rates again. On September 18, the Fed cut its overnight rate for the first time since March 2020, while also signaling that further rate cuts could be expected.

The chart below shows the inflation rate in the US. The blue line is the Consumer Price Index – Urban measure, which is the most-often cited measure of inflation. The orange line is the same CPI measure, but excludes certain highly volatile components of the index, such as food and energy.  

The Fed’s preferred measure today is called the Personal Consumption Expenditures deflator, which is measured a little bit differently. The CPI measures the cost of a representative basket of goods and services for urban households, while the PCE measures the cost of goods and services for all households and nonprofit institutions. The CPI also measures a smaller number of items than the PCE because it only includes expenditures made by a household whereas the PCE includes purchases made on behalf of a household (e.g., medical care paid for by employers). At various times since 2021, these measures diverged quite a bit, but they recently all seem to be trending back towards 2%.

^[1] Before the 1977 amendment to the Federal Reserve Act, maximum employment was already a legislated goal, applying to the whole of the federal government, through the Employment Act of 1946. One of the Employment Act’s additional legislated goals, maximum purchasing power, had been interpreted as amounting to a price-stability goal.

^[2] Inflation soared in the US as well as countries that followed the monetary/fiscal stimulus playbook – notably the Euro zone, the UK, and Canada. Inflation remained subdued in non-dollar/non-euro countries, such as Switzerland, Japan, and China, and in the Middle East Gulf region.

This cut signals a transition from the Fed’s aggressive inflation-fighting stance to a more balanced approach.  Fed Chair Jerome Powell stated, “We have gained confidence that inflation is moving toward 2%.” However, he also noted that inflation “remains somewhat elevated,” indicating ongoing vigilance.

This rate cut comes against a backdrop of mixed economic signals. The Fed acknowledged that economic activity continues to expand at a solid pace. They also pointed out that job gains have slowed and the unemployment rate has increased to 4.2%. This trend in the labor market was a key factor in the Fed’s decision, as they aim to prevent further job losses and maintain maximum employment.

The implications of this rate cut are far-reaching. For consumers, it could mean lower borrowing costs for mortgages, auto loans, and credit cards. This could stimulate spending and investment, potentially boosting economic growth. For businesses, cheaper loans could encourage hiring and expansion plans, while companies with adjustable-rate debt on their balance sheet could see their interest burden decrease.

Interest Rates vs. Tech Multiples

The level of interest rates – particularly longer-term interest rates for 5- to 10- year bonds – has a significant impact on the valuation multiples for SaaS companies. We have often seen SaaS multiples rise during periods of falling interest rates (notably, from the middle of 2020 to the end of 2021) and then drop when rates start rising (for instance, from the middle of 2022 to the end of 2023). During these periods, multiples for high-growth companies have generally been far more volatile than those for slower growers.  

The chart below shows the median SaaS multiple in our proprietary PVC SaaS Index® (which currently includes 99 publicly traded US SaaS stocks) and interest rates. I have used a measure that I call the Inverse 10-Year Bond Yield, which is simply the reciprocal of the constant maturity 10-year Treasury Bond. I’ve just taken the yield-to-maturity of the current “on the run” 10-year Treasury to create a measure that positively correlates with SaaS multiples.

As you can see, the lines for the most part move together, with a slight lag that shows Treasury yields leading and SaaS multiples following by about a quarter. The correlation between these two measures since 2014 is about 0.6, which means that 60% of the movement in SaaS multiples can be explained by interest rates. Stunningly, the correlation more recently, since 2020, is close to 0.9.

SaaS valuations are essentially the sum total of all of the future cash flows of a company. Most SaaS companies are unprofitable, so their cash flows are out in the future. The further into the future we expect a cash flow, the more we discount it (see “Time Value of Money”).  As interest rates rise, those future cash flows become worth less in today’s dollars.

In the public markets, the value of a stock is often comprised mostly of cash flows over 5 years out, what investors call the terminal value. It is the value assigned to all future cash flows beyond the ones forecasted in a discounted cash flow model. Practically speaking, analysts often model 5-10 years into the future with any degree of certainty, but how we think a company performs in years 11 and beyond will have an impact on how much we’re willing to pay for a share of the company today.

Because of this, we must estimate the value of those distant future cash flows – hence the need for a terminal value. Investors typically use something called the weighted average cost of capital (WACC) to discount those distant, over-the-horizon cash flows. The full formula for the WACC is here, but the punchline is that as interest rates rise, so does the WACC. For higher-risk assets with distant cash flows (like growth tech companies), investors demand an even higher rate of return and will discount future cash flows by a higher discount rate, which lowers the overall value of the company.

Short-Term vs. Long-Term Rates

So, does this mean that tech valuations should improve? Well, not necessarily. The Fed only cut short-term rates (such as overnight bank lending rates) because that’s all that it can really control. Short-term rates falling doesn’t necessarily mean that long-term rates (which are more closely correlated to tech valuations and the “terminal value” of cash flows) will fall in tandem. 

In fact, in the weeks since September 18, the 10-year bond yield has risen. 

Why is the yield on longer term Treasuries rising while short-term rates are falling?  

The interest rates on long-term securities reflect various assumptions about things like long-term inflation, the supply and demand for Treasuries, and the alternative returns offered by things such as stocks, real estate, or gold. When “expected inflation” rises, interest rates tend to rise as well because investors now have to compensate for the decrease in purchasing power of the money they are paid in the future.

It appears that yields had already priced in this rate cut (and probably the next 100 bps of cuts as well), so the Fed’s moves didn’t matter. In fact, after a robust labor report on October 4 showed unemployment falling to 4.1% along with higher wages, the market may now be fearing stronger demand for borrowing and higher inflation, which elevates yields.

Paradoxically, it’s possible that the Fed re-ignites inflation fears by loosening monetary policy too quickly while the economy is growing and at full employment.^[1] This could stoke fears of higher inflation, and along with that, push long term yields higher as well.

Conclusion

The Fed cut rates last month by a larger-than-expected 0.5%. This long-awaited cut may lead to a better valuation environment for tech stocks because historically lower rates correlate very strongly with higher valuations.

However, it appears that longer-term interest rates didn’t fall after the Fed cut. In fact, they have been rising in the weeks since. It’s likely that the Fed cut was largely understood and expected by the market and that the continued low unemployment rate and ongoing wage growth are pushing up fears of inflation, which in turn is pushing up yields.

In fact, the Fed may have inadvertently stoked this fear of “higher for longer” inflation. 

It is unusual, to say the least, for the Fed to initiate a cutting cycle with a 0.5% point cut, especially odd at a time when, according to Fed Chairman Jerome Powell, the economy is “in a good place.” The Fed has “growing confidence that the strength in the labor market can be maintained,” all while fiscal policy (i.e., deficit spending) remains very loose.

This is the last in a string of surprises and odd decisions pulled by the Fed, under the leadership of Jerome Powell. These missteps began with the decision in early 2021 to continue to expand the money supply even as the economy was expanding. That was followed by a view that inflation was “transitory,” when it was clearly not, as well as the view that there was an uncomfortably high risk of a recession in 2022, which led to an “easy money” policy throughout 2022 and consequently 40-year highs in inflation.

Now, the Fed risks a third misstep, a kind of “mission accomplished” declaration in the battle against inflation.

^[1] Full employment is an economic state where all available labor resources are being used in the most efficient way and there is minimal or no unemployment.  Many economist think that when this condition exists, any further decrease in unemployment will cause the inflation rate to accelerate.