Rates Are Rising . . . What Now?

Long-term interest rates are on the rise again, and this time the stars could be aligned for a sustainable move upward. Consider the following:

  • GDP growth came in at +4.2% for the second quarter of 2018; most expect the third quarter to come in anywhere from 3% to4% on the back of tax cuts and higher government spending.
  • The unemployment rate has declined to 3.9%, and there is ample anecdotal evidence that companies are having problems finding qualified workers.
  • Growth in Average Hourly Earnings, at +2.9% in August, has accelerated to its fastest pace in over 9 years.
  • Inflation at the consumer level, as measured by either the Personal Consumption Expenditures (PCE) deflator or the Consumer Price Index (CPI), is now at or above the Fed’s target of 2% on both a headline and core basis.
  • There has been a wave of bond supply (issuance) hitting the market as corporations rush to lock in low interest rates so that they may reward their shareholders with buybacks and dividend increases. The increase in supply may become difficult for the markets to digest without the incentive of higher interest rates.
  • As a result of the tax cuts and spending bill, the federal budget deficit is expected to increase by about $183 billion to $849 billion in 2018. The deficits are expected to grow again in 2019 and beyond. Higher deficits means more Treasury supply hitting the markets, especially as the capacity to borrow from the Social Security Trust is rapidly declining.
  • Additional Treasury supply is hitting the markets as the Fed continues to shrink its $4.2 trillion+ bond portfolio.
  • The odds of at least 2 more Fed interest rate hikes this year have increased to 77% from about 45% at the end of June.
  • The Trump administration’s “America First” foreign policy is causing some countries to seek alternatives to the dollar as its primary reserve currency. Faced with an asymmetric trade war, the Chinese could decide to sell some of their large portfolio of Treasuries as a retaliatory measure. Russia has already dumped nearly all of its Treasury holdings in response to economic sanctions.

So there are plenty of factors conspiring to send interest rates higher. Even so, a sustainable rise in yield above 3% on the 10-year Treasury bond has been a difficult feat to achieve over the past several years. And while this time does feel different due to our underlying economic momentum, we still wonder. Our questions are many:

  • Will the domestic economic momentum continue as the benefits of tax cuts and higher deficit spending subside?
  • Will the middle class begin to see larger benefits from the economic expansion?
  • How much can the US economy “decouple” from the rest of the world, which appears to be back in malaise?
  • How much will arbitrage opportunities limit the increase in US interest rates vis a vis other countries like Germany? Also, does it make sense that a country like Italy, which is teetering on the brink of a financial crisis, has a lower borrowing cost than the United States?
  • How much of a dampening effect will a rising dollar have on domestic economic growth?
  • Will rising trade protectionism crimp growth prospects? (I should note that trade barriers are inflationary. However, the Fed is likely to view such inflation as non-recurring and therefore would be unlikely to adjust its monetary policy in response)
  • Will we be able to resolve the many geopolitical problems (Syria, North Korea, Iran, etc.) that have led global investors to favor the safety of the US dollar and US Treasury bonds?
  • And perhaps most importantly, how much of a dampening effect will higher debt-servicing costs have on an economy as heavily in debt as the US has become?

Our suspicion is that reaching escape velocity will not be so easy given our massive accumulation of debt. The notion that “interest rates are still low compared to historical averages” is not valid. The only thing that matters is where borrowing costs are relative to recent history. The yield on the 10-year Treasury note has more than doubled from its low of 1.36% in mid-2016 to its current level of 3.07%. According to data from the Fed, our economy has a debt load of over $65 trillion, much of which is either short-term or variable-rate. Federal government deficits are rising rapidly, entitlement spending is set to surge, and our friends at the Treasury have failed to use the low-rate environment to extend durations on the public debt. Growing our way out of the debt problem appears to be a tall order. So while today may not be the day to take some stock gains and reallocate to bonds, we think the day will come sooner than most expect.

For those expecting that the recent acceleration in economic growth will be sustainable, it probably makes more sense to buy bonds on the short-end of the curve. The yield on the 2-year Treasury has increased to about 2.8% – very close to the current yield on the 10-year. Buying the 2-year rather than the 10-year entails much less price volatility in the event of further increases in interest rates. For those who think our recent growth spurt could be fleeting, buying longer-dated bonds might offer the opportunity for price appreciation if/when interest rates come back down. Either way, investors now have the opportunity to earn respectable rates of interest that are free of credit risk, which is something that has been unavailable for a very long time.