IT’S ALL ABOUT INTEREST RATES?

Capital Market Comment
October 11, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer

Last week’s rise in interest rates appeared to arrive like a shock wave with the 10-year U.S. Treasury rising over 15 basis points in several days. Many pundits and media talking-heads ascribed the equity market pullback to the rate rise. After reaching new highs the week before with all the accompanying positive rhetoric, a week later it all seemed to change with a different story line.

Traders, the algorithms, and program trading (which dominates the daily volume on the exchanges) react swiftly – negatively and positively – to what appears to be incremental information, and thus exacerbates price movements. Have the fundamentals really changed? The answer is NO! With strong fundamentals – economic growth, expanding employment, double digit profit growth, etc. – it should be no surprise that rates have risen. The unexpected element could well be that they stayed so low for so long and the uptick was swift.

What has been little discussed is that the 35-year secular bull market in bonds ended in 2016. With the 30-year and 10-year U.S. Treasury Bond (non-callable) rates falling from near 16% in 1981 to 2.10% and 1.37% respectively in 2016, they now stand at 3.40% for the 30-year and 3.23% for the 10-year.

What often gets lost in the discussion is the realization that when rates rise, the value of your bond portfolio falls. After 35 years of declining rates (with interim cyclical rises and declines), bond portfolios generally appreciated in value. The financial community has had little experience with a rising rate (falling bond values) environment. This phenomenon was particularly evident when investors (under the advice of their brokers) kept pouring money into bonds (an easy sell) when the 10-year rate rose more than 2.5 times. Many long-term bond portfolios invested over the last two years have experienced losses and in the changing environment are likely to experience further asset depreciation. According to Barron’s, this year investment grade bonds have experienced a loss of 2.2% through September. The first week in October added to that loss.

What is particularly important is that many asset allocations were heavily over-weighted to bonds when the most compelling values were in stocks. This imbalance can prove problematic in the coming year as bond investors get increasingly disappointed.

Interest rates are one of the most important factors in equity market valuations; and rising rates are a constraint. At the same time, rising corporate profits generated from economic growth are a positive impetus. The issue becomes: are rates high enough to stifle growth and set in motion recessionary forces?

The behavior of interest rates suggests otherwise. The recent rise in the 10-year relative to the two-year suggests that the yield spread has widened. The narrowing of the spread was a concern since inverted yield curves precede recessions. In fact, Fed Board members and Federal Reserve Presidents have voiced concern in this regard.

Additionally, the yield spread between low-grade bonds (junk) and the 10-year Treasury (risk-free) has not widened. In fact, it has narrowed slightly in recent weeks. Early signs of economic difficulties show up in a deterioration in this relationship. The fiscal stimulus (tax cuts) is providing impetus for economic growth into 2019. This stimulus does provide encouragement to investors in low grade bonds (the riskiest part of the fixed income market).

However, over the next 12 to 15 months, the dynamics in that segment of the bond market are likely to change.

The Federal Reserve has provided a trajectory for short-term interest rates – (one more this year and three next year) in order to move toward an equilibrium (a neutral rate that is neither stimulative or restrictive).

It appears that the current Federal Funds Rate is stimulative (below the neutral rate) and remains below the inflation rate, hence a negative real rate (stimulative). However, if the Fed moves rates according to its trajectory (that may not happen – depending on economic conditions) it is quite likely that restrictive conditions will emerge.

It is interesting to note that the Federal Reserve Bank of St. Louis President, James Bullard, indicated in a recent speech that he believes we are near the neutral rate now. This level is 75 basis points below what is generally the consensus among Fed officials.

Unlike stocks, bonds with low coupons have little room for appreciation. On a risk-reward basis, the risk of loss is higher in a strong economy and one where Federal Reserve policy is changing. Since a recession does not appear close at hand, stocks should benefit from a growing economy and profitability, as well as the increase in ownership for shareholders due to the corporate tax cut (35% to 21%).

Moreover, an uptick in inflation (which seems likely), should be easily passed on by most corporations while bonds become the victims as rates rise. When interest rates rise sufficiently, and liquidity stress develops, then the underpinning of the equity market weakens, and a bear market ensues. A correction can occur at any time and individual stocks go through such patterns periodically; but bear markets are fundamentally driven.

At this juncture, the equity market’s reaction appears to be in part a response to the “new reality”: the speed of the rate rise along with rates in a new, but higher range. Even a 3.5% 10-year Treasury rate offers little competition to equities. With the S&P 500 likely to generate a 6% earning yield and growing, a 1.8% dividend yield and growing, continued liquidation of stocks through M&A, the bias in equities remains upward.

One of the forces likely to keep rates from rising too sharply is low overseas rates. The yield on the 10-year German bond is 57 basis points, generating the widest spread to the 10-year U.S. Treasury. Also, the stability/strength of the dollar provides some currency benefit to foreign investors.

Economic developments in the European Union and China point to a slowing of growth, and thus little incentive to alter their current accommodative policy. In China, due in part to trade conflicts, the Central Bank has lowered reserve requirements again, injecting more liquidity in the system and allowing the Yuan to fall further. The road to a world currency for China has once again hit a roadblock. With rates remaining low overseas, rate pressures in the U.S. are likely to be generated domestically.

Although the Fed has been quite transparent in its intentions, the number of rate increases could well be less due to the impact of higher rates on commercial and residential construction, automobiles, consumer credit, etc. Trade policies are already being felt as evidenced by the International Monetary Fund having reduced its forecast for world economic growth. However, given the effects of employment and wage gains’ impact on overall consumer spending, the adverse impact could be quite small. Moreover, the monetary authorities may well respond to any small change as a justification for slowing the rate rise in order to enhance the longevity of the economic expansion.