The Path to Higher Interest Rates
Legacy Wealth Planning in Reno, sheds some light on the topic of higher interest rates. Thanks for the guest post, Phil. Higher interest rates – it’s a story or perhaps just a preview of what we have been talking about for a long time. The difference this time is a few nuances that alter the story:
First, I don’t believe this is a change in policy – Ben Bernanke and the Federal Reserve still believe very much in providing liquidity and easy money right now, but are simply illuminating their thoughts. The Fed was always going to move rates up eventually, and phasing out QE by next summer is very reasonable. Though it is necessary, it is a large move, and a large amount of money to move out of the system. This could be potentially disruptive in the short-term, but with the shrinking deficit and the economy growing, the poorer choice is to continue the QE program indefinitely.
Secondly, higher interest rates are inevitable, but I think there will be no long-term detrimental effect on stocks. While this has not been the effect recently, I think it’s because the new uncertainties of higher rates on the economy and stock prices have sent some investors into hiding. The economy, though not super energetic, looks pretty good right now and the economic numbers seem to be supporting this and going in the right direction. A return to more normalized interest rates should actually give confidence to the economy and markets.
Third, I don’t think that bond market has overreacted. The recent rise and expected higher rates to come are not a surprise. Yes, they did move up quickly, but the absolute numbers may still be even a bit too low. Consider that over the last year, the rate of inflation is about 1.7% and the current ten-year Treasury as of today is just 2.65% (just 95% difference between the two!). Using historical spreads, the ten-year Treasury should be closer to 4%, if not more.
Fourth, after this recent correction, equities are relatively even cheaper to bonds than they were. Is this uncertainty? I would argue there is more certainty, but the rub may be that the Fed has been justifying the QE program for the last few years, telling us that the economy would be horrible if it wasn’t there. So when the possible tapering announcement came, investors became frightened and sold equities not believing that they can ride the bike without training wheels. We should get used to it; I don’t think we’ve seen the end of higher rates.
Fifth, the economy is moving forward first and foremost because of the prices of homes. They are going up, not because of mortgage rates being low, rather because there is not enough supply. Auto sales are in the same boat, as are airlines and occupancies for hotel rooms and apartments. The increase in interest rates convinces people that the economy is OK. This in turn puts a fire under them to get things done, and make major purchases before they are too expensive or interest rates get too high.
So don’t be frightened by the news – sentiment always gets hurt in a pullback as the economy rebalances itself and I think waiting for a better day to buy is a good way to be left behind.