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The Rate Rollercoaster: The Scariest Part is the Beginning

Saturday, October 22, 2016 4:57
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(Before It's News)

Interest ratesMany investors have expressed concerns about the bond markets, specifically the negative rates being experienced around the globe as central banks attempt to boost economic activity by lowering rates.

Central banks’ actions have taken a toll on an increasing number of retirees that has depended on the income from their savings as they have seen the “riskless” government bonds go from 5%+ to less than 1%.  There is increasing speculation that the central banks have not accomplished their goal of increased economic investment and the recovery to pre-2008 global economic growth.  Additionally, in recent weeks, an increasing number of economists and central bankers have noted that the unintended consequences of artificially low rates may be doing more harm than was previously anticipated.

This, in combination with the typical 35+/- year rate cycles that have occurred throughout history, lead many to think that the world may be on the cusp of a new cycle. With the heightened market awareness of the potential beginning of a rate cycle, some questions come to mind: By how much will rates rise, and who is most impacted by this rise?

rate1

There are two rules of thumb with respect to interest rates that may assist in ball-parking the potential impact.  To be clear, the rules are imperfect and are by no means “laws.” No one will be jailed if they are broken, but history suggests that thinking that ‘this time is different’ can dramatically hurt one’s ego and wallet!

The first rule of thumb is that short-term treasury interest rates (VGSH, SHY, SST) should be tied to the experienced level of inflation.  The reasoning is that idle money should not decline in value — in real terms — over a short period of time.  For that to be true, the rate of return on idle money should equate, roughly, to expected and experienced inflation.  Historically, there has been a link, albeit loose, between the two.  For a significant portion of financial history, the ratio, as shown below, has centered around 1.5x, meaning that short term rates have typically been about 1.5 times the amount of inflation experienced.  This rough average existed for the first 20 years of the current cycle, but dropped to approximately 1.0x in the early 2000’s.  Since the recession, this ratio has dropped even further, reaching a level where investors are now losing money to inflationary pressures rather than maintaining or growing purchasing power.

rate2

The conclusion one can draw is that either inflation needs to fall or rates need to adjust up.  With wage pressures starting to come into play, it appears more likely that rates will need to rise.  To get back to historical levels, we would need to see short term rates adjust from the current sub-1% to a level closer to 3.0%.  That would be a significant adjustment for the market to absorb.  To soften what looks like an extremely large increase, there are several unknowns that make the error bands around it quite large.  However, it does indicate how much movement we could see before we even get back to historical levels.

The second rule of thumb is the 10 year risk free rate (ITE, IEF, VGIT) should approximate expected nominal GDP growth. The linkage relies on the idea of opportunity cost.  The investment markets will push longer-term interest rates down to the point of equilibrium where an investment that is explicitly tied to expected inflation and economic growth can no longer be justified when a better risk-adjusted rate can be had elsewhere.

From the chart below, the yield on the 10 year bond also appears to be depressed in comparison to historical data, with the ratio remaining well below past cycles.  With the historical average ratio approximating 1x, and with nominal growth estimates being around 3.5-4.5% in the US for 2017, the 10 year benchmark yield would need to jump well over 100% to return to the realm of historical levels.

rate3

If central banks were to give up on the idea of monetary easing and investors were to start to respect the increasing amount of inflation in the US, the weight that has been placed on rates would be alleviated and the movement in rates would be swift.  There is a consensus that rates will be lower for longer, however, because we collectively tend to be anchored to our current experiences.  With data increasingly pointing to a recovery of inflationary pressures, the chain tying us to our anchor may be close to breaking.

There is little doubt that, if such a swift move were to occur, the world’s markets would have to adjust.  The question then becomes what would be impacted the most.  In most cases, the prospect of rising rates indicates the end of an economic cycle and the increasing probability of recession.  It typically favors areas that can weather sluggish economic growth.  However, this time may be different, as the first phase of a potential rate rise would be to a point of normalization rather than a stifling of economic activity.

If that were to be the case, industries that have been benefitting the most with rates below their natural level would be the likely victims.  These people also tend to be the most heavily indebted or the most dependent on low cost debt.  Utilities (XLU, VPU, IDU), real estate (VNQ, IYR, RWR, XLRE), basic materials (XLB, VAW, IYM), and staples (XLP, VDC, FXG) may be the industries that are hardest hit as funding becomes more expensive.  Interesting enough, these industries have been the ones towards which investors have gravitated in their search for yield, safety, and lower volatility.

About the Author: Joseph Hosler

joseph-hoslerJoseph Hosler, CFA, brings 21 years of investment experience serving the needs of large institutional clients. His background includes portfolio management and investment analysis, predominantly focused on domestic and international public companies. Prior to the founding of Auour Investments, Joe led investment activities within various sectors at Pioneer, Babson Capital, Putnam Investments, and Independence Investment Associates (IIA). While at IIA, Joe drove the effort to design, develop, and launch one of the first quantitatively driven tax efficient investment approaches focused on individuals and taxable organizations. Joe holds an MBA from The Darden School of the University of Virginia, as well as, a B.S. and M.S. in Mechanical Engineering from Boston University. He is an active volunteer within his community and currently sits on the Boston Security Analysts Society’s Strategists/Economists Subcommittee. Joe resides in Wenham, MA with his wife of 22 years, two children and three dogs.

You can contact Joseph via email at jhosler@auour.com or on Twitter @jbhosler.

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