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5 Things To Ponder: The Interest Rate Conundrum

Tyler Durden's picture




 

Submitted by Lance Roberts via STA Wealth Management,

After several months of quite complacency, investors were woken up Thursday by a sharp sell off driven by concerns over potential rising inflationary pressures, rising credit default risk and weak undertones to the economic data flows. One of the primary threats that has been readily dismissed by most analysts is the impact from rising interest rates. Last week, the following chart was circulated again which shows that stocks perform well during rising interest rate environments:

interest-rates-stocks.jpg

Now, this is surely clear evidence that one would want to be long stocks during a rising interest rate environment, right? Not so fast. There are a couple of important points you may want to consider before jumping on the bandwagon.  First, let's look at the specific periods analyzed. 1993-2000 was the massive "technology" driven boom which covers the entire first half of the chart.  2003-2006 was the majority of the real estate/liquidity bubble while the last two periods were during a Fed induced liquidity push. In otherwords, there is little "normalcy" during this entire period.

However, more importantly, is not what happened DURING the periods of rising rates, but rather what happened following those periods. Those mysterious dashed vertical lines on the chart above represent what is NOT being shown to you.  For clarity purposes, we need to look at the entire data series to see what the actual impact of rising rates on the financial markets has been.  I have highlighted peaks in interest rate increases and corresponding events.

Interest-Rates-10Yr-Crisis-080114

The issue with rising interest rates is that higher borrowing costs lead to slower economic activity and a quelling of inflationary pressures. The Federal Reserve believes they can control the economic engine by using monetary policy as a governor. This is kind of like playing "Jango" where the object is to weaken the structure by removing supports without toppling it entirely.  Of course, like the actual game, the Federal Reserve's track record of successfully managing the economy is "poor" at best.

This weekend's reading list is a set of viewpoints on the Federal Reserve and the potential impacts from an increase in interest rates.

1) Rising Rates: The Good, The Bad...No Ugly by Doug Peebles and Ivan Rudolph-Shabinsky via Pragmatic Capitalist

[Note: This piece is really specifically talking about individual bonds versus bond funds.  Bond funds do not mature and are strictly a play on the direction and trend of interest rates. This is an important distinction and a primary reason why I continue to suggest owning bonds in portfolios, rather than bond funds, which reduce portfolio risk and volatility, provide principal conservation and an income stream.]

"By their nature, bonds are generally sensitive to interest-rate movements—when rates rise, prices typically fall. With short-term rates on the way up, other interest rates won’t stay low forever, either. But across all bond sectors, from high grade to high yield, rising rates can have positive effects. We believe investors should see a rise in rates as, ultimately, a good thing for bond portfolios. (And by ultimately, we mean just a few years.)"

Distenfeld Rising-Rates-Improve d8-1

"What’s the source of this higher growth? First, as you reinvest the coupon income that your portfolio pays, you’ll be able to reinvest it at higher yields. Income matters: for investors who use bonds to generate income, rising rates change from a threat to an opportunity. Second, as the bonds in your portfolio mature, their price pulls back to par, and you can reinvest their principal value in newer, higher-yielding bonds."

2) Rate Expectations by Buttonwood via The Economist

"This is a crucial question. The Federal Reserve’s benchmark rate averaged 2.96% in the first decade of the 21st century but 5.15% in the 1990s. Imagine the effect on the borrowing costs of mortgage-holders or small businesses if rates moved back to the latter level.

 

Before homeowners and small business breathe too big a sigh of relief, remember that this discussion has concerned the neutral level of rates. Rates could go higher if central banks decide they need to rein back the economy, perhaps because inflation returns. Richard Barwell of Royal Bank of Scotland says there may be too great a belief in 'the miracle of immaculate monetary exit'. This would require monetary stimulus to be withdrawn before the economy recovers, not after, and for central banks’ economic forecasts to be unerringly accurate.

 

Since central banks failed to anticipate the debt crisis of 2007-08, this is an attitude of the purest optimism. Given the debt burden still facing the rich world, the risks of policy failure are enormous."

3) Yields Likely To Keep Falling by Erik Swarts via Market Anthropology

"Despite the strong GDP print yesterday that reinvigorated the raise-rates camp and sparked an almost 4 percent rally in 10-year yields, we continue to feel these participants are once again placing the cart before the horse, when it comes to what Chairwoman Yellen has repeatedly articulated will be a "considerable time" after the QE programs are wound down this October - and when they consider their next policy response.

 

From our perspective, where the rubber meets the road with the specifics of actually raising rates is much further off in the future and only after the markets normalize to this rather significant shift in support - from both a structural and psychological point-of-view. (For more of our thoughts on the effects of this normalization and why we don't find parallels with recent history, see Here)

 

With respect to 10-year yields, the frictions from the end of QE should continue to support the Treasury market and we expect the next step lower in yields to be taken as the markets stroll into August."

Market-Anthropology-080114

4) Investors Underestimating The Path Of Policy by Rain Capital Management

"Interest rates may be the single most powerful force in capital markets.  They are quite literally the cost of money and determine everything from the value of bonds to the price people are willing to pay for equities.  We don’t think for a second that the process of rate normalization will be as uneventful as the market seems to be pricing in.  No bell will ring or date certain set for unwinding what is now an extremely outdated policy stance.  The idea that investors can simply get out of the way when the time comes is unlikely when considering how flatfooted they have been in the midst of interest rate volatility in 2013, rate hikes in 2004, 1994, and so on.

 

Investors aren’t getting paid much to take risk, so they’re taking more risk in an attempt to make up for it.  We’d much rather use this opportunity as a pit stop; a time to fortify portfolios during which the cost of not being fully exposed is minimal but the cost of making a mistake could be large. To paraphrase Warren Buffet, reducing risk may be uncomfortable, but not as uncomfortable as doing something stupid."

5) Fed Creating Bubbles By Inflating Equity Risk Premium byAswath Damodaran via Musings On The Markets

"If you accept the notion that the Fed controls interest rates (that many investors believe and Fed policy makers promote) or even my lesser argument that the Fed has used its powers to keep rates below where they should be for the last few years, the consequences for valuation are immediate. Those lower rates will push up the valuations of all assets, but the lower rates will have a higher value impact on cash flows way into the future than they do on near-term cash flows, making the over valuation larger at higher growth companies.

 

Consequently, a reasonable argument can be made that the Fed has been an active participant in, and perhaps even the generator of, any bubbles, real or perceived, in the market. In my post on market bubbles, I did agree with Ms. Yellen on her overall market judgment (that traditional metrics are sending mixed messages on overall market valuation) and used the ERP for the market, as she did, to back my point. In particular, I noted that the implied equity risk premium for the market at about 5% was high by historical standards (rather than low, which would be a indicator of overvalued stocks). However, breaking the ERP down into an expected stock market return and a risk free rate does point to an overall disquieting trend:"

ERP-and-Risk-free-080114

"Note that all of the expansion in ERP in the last five years has come from the risk free rate coming down and not the return on stocks going up. In fact, the expected return on stocks of 8% at the end of 2013 is a little lower than it was pre-crash in 2007 and if the risk free rate reverts to pre-2008 levels (say 4%), the ERP would be in the danger zone. Put differently, if there is a market bubble, this one is not because stock market investors are behaving with abandon but because the Fed has kept rates too low and the over valuation will be greatest in those sectors with the highest growth."


The last article is most interesting as two of the primary "bullish arguments" has been the spread between earnings yield (the inverse of the P/E ratio) and the interest yield on bonds, and the non-inversion of the yield curve.  I have argued in the past that the so-called "Fed Model" is flawed for many reasons. However, an increase in interest rates will very quickly nullify both of those bullish arguments because the denominator in both cases can rise MUCH faster than the numerator.

 

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Fri, 08/01/2014 - 16:38 | 5034737 junction
junction's picture

Obviously, the world is doomed.

Fri, 08/01/2014 - 16:49 | 5034790 SAT 800
SAT 800's picture

Wakey, wakey. As Bob Dylan said; "There's something goin on here, Mr. Jones., and you don't know what it is, do you Mr. Jones?"

Fri, 08/01/2014 - 17:21 | 5034994 Oracle 911
Oracle 911's picture

The game's name is "Jenga", not "Jango" but we get it.

Fri, 08/01/2014 - 16:44 | 5034768 kaiserhoff
kaiserhoff's picture

Good points, but pocket change compared to what rising rates will do to real estate.

Won't help car loans either.  Better move that tin while you can.

Fri, 08/01/2014 - 17:05 | 5034895 knukles
knukles's picture

But ain't all them rich peeeples wit da Section 8 thingamajigs all cash buyers?

Fri, 08/01/2014 - 17:45 | 5035127 kaiserhoff
kaiserhoff's picture

Uncle Sugar be the worlds best slum lord.

One reason accountants can not get a handle on the true national debt, is that you can never trace all of the millions of stupid contracts the Feds have created on our behalf.

Fri, 08/01/2014 - 18:37 | 5035427 Amish Hacker
Amish Hacker's picture

The accountants are still scratching their heads about how to account for the $12 billion in shrink-wrapped hundred dollar bills sent to Iraq in 2006-7. We're talking pallets of them, 281 million notes weighing 363 tons, multiple C-130 flights. http://www.theguardian.com/world/2007/feb/08/usa.iraq1  Every bit of it vanished into the war, leaving no receipts.

Fri, 08/01/2014 - 16:48 | 5034779 Rainman
Rainman's picture

Seems as good a time as any to post the close on the 10yJGB @ .53

Fri, 08/01/2014 - 18:08 | 5035260 kaiserhoff
kaiserhoff's picture

Janet must be green with envy.

Fri, 08/01/2014 - 16:55 | 5034821 buzzsaw99
buzzsaw99's picture

there is no market.

...it was barzini all along

Fri, 08/01/2014 - 17:02 | 5034877 HUGE_Gamma
HUGE_Gamma's picture

SHORT ZN!!!!

Fri, 08/01/2014 - 17:45 | 5035132 WTFUD
WTFUD's picture

Looong Z/H.

Fri, 08/01/2014 - 17:31 | 5035044 adr
adr's picture

Seasonaly adjusted car sales have had the best year since 2005, yet every dealer seems to be giving cars away.

Local Honda dealer had a special lease on a Civic for $29 a month for two years with $2300 down. That is insanity. I was offered a $26k Accord for $19,500. 

If car sales are going so great, why the massive incentives?

Fri, 08/01/2014 - 17:58 | 5035214 IANAE
IANAE's picture

They're in a death-match race for what's left of subprime consumer wallet...if they don't lock in what's left before the credit well runs dry they will miss out until the next credit/buying cycle.

Car biz is a funny biz...really point-of-sale product - remarkable given the $$ involved - they have to have metal on lots in order to sell so they overbuild to stock the lots then discount to move metal.

...one might think they'd learn after the last go round but apparently not, would appear to be the case that securitization markets are still hungry for these flows...I wonder what spreads they're trading at these days.

Fri, 08/01/2014 - 19:56 | 5035815 robertocarlos
robertocarlos's picture

On a brand new Accord?

Fri, 08/01/2014 - 19:24 | 5035670 OnceandForever
OnceandForever's picture

Pure and simple...as is the case with Japan ($15 Trillion in debt and 55 bps for a ten year note yield...) our markets will crater and our rates will fall...why? Because at $18 Trillion in debt, we cannot afford higher rates.   Please understand that we do not have any idiots like Paul Volker around anymore.   LOL !!!  Rates will fall to a 1 handle by year end. 

Fri, 08/01/2014 - 19:34 | 5035717 andrewp111
andrewp111's picture

I see no evidence that rates will be rising anytime soon. If anything, rates are more likely to fall to record lows than they are to rise.

Sat, 08/02/2014 - 00:23 | 5036628 Dingleberry
Dingleberry's picture

RE can't handle even a full point rise....and autos are now going full-tard back into subprime and mortgage-like amortizations.

Rates aren't going anywhere, perhaps a bit more down.

Sat, 08/02/2014 - 12:56 | 5037765 The Merovingian
The Merovingian's picture

Spot on.  All market logic left the building when Elvis did.  TPTB may 'talk about rates rising' but they know the skeletons in the closet will all come tumbling out if rates were actually to move up in any significant way.  Welcome to Japan, and say sayonara to any hope that the American middle class will ever rise again.  Hedge accordingly on all fronts.

Sat, 08/02/2014 - 02:16 | 5036789 hedgiex
hedgiex's picture

When the free market is held captive by Banksters and Oligarchs, the markets are not the microcosms of the economies. That say rising default risks or whatever cause the gyrations in the markets are hogwash.

The interest rates are determined by the CBs the instruments of the Oligarch Class to keep the game going. That they own the printing presses without controls mean that no global traders want to f**k with it. The only group that has some influence on the interest rates are the creditor nations. They are too busy with their own problems to visit these casinos. If they play, they paly with real things eg real estates, commodities, etc that they can touch and see not papers.

Why these Oligarchs are still around is there are still juices left with remaining savings and pensions funds to raid. The little people or muppets that they have labeled can do much better in getting their remaining savings/pensions wherever possible out of reach of the snake oil salesmen/pundits. These no skins in the game predators are also getting more desperate in growing illiquidity across markets where their concotions cannot fly.

Sat, 08/02/2014 - 07:50 | 5037060 AdvancingTime
AdvancingTime's picture

The term "the new normal" has not been used much as of late, but going forward it may be about to return. Many investors and the public at large may be about to realize that central banks can only do so much through printing money and lowering interest rates. Both these actions carry with them some very strong and nasty side effects.

Markets have become very distorted as money has flowed into risky assets in search of higher yields. It could be we are about to see the markets morph into a "realizing market", one that grinds slowly downward. Another possibility is that at some point the wisdom of buying every pullback changes and the market simply drops like a stone. More on what the future might hold in the article below.

http://brucewilds.blogspot.com/2013/06/realistic-expectations-for-econom...

 

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