- Rates cannot go lower but higher rates would destroy wealth and lead to a recession.
- The FED is in a difficult position and rhetoric shifts can be expected.
It is every central banker’s target, the elusive 2% rate of inflation. We cannot know when, but should expect that it will be achieved and prepare accordingly. Since rising interest rates help to keep inflation in check, once the target is reached, as strange as it sounds, rates should also rise to compensate. This article is going to analyze what is happening, what will probably happen, and how it will affect investments.
The current situation is one of persistently low interest rates on a global scale. The U.S. recently increase short-term rates by a negligible amount, while Japan and Europe continue with their easing policies.
Figure 1: Interest rates in Japan, Europe and U.S. Source: FRED.
Once inflation reaches the 2% target, inevitable consequence will be higher interest rates since it is the only option that prevents inflation from escalating. It’s hard to imagine now, but with all central banks hell-bent on achieving their “goal,” it will become a reality, maybe sooner than most expect. It might take central banks putting money directly into our hands via “helicopters,” but eventually the target will be reached and we will see interest rates come back to normal historical levels.
The FED forecasts its funds rate to be between 2% and 3.5% in 2017. If achieved, it means that all other interest rates, from bond yields to mortgages, will be higher than that. A plausible scenario is that 10-year bond yield is 1.5% higher than the fed funds rate and the expected stock yield 2% above that.
Figure 2: FED’s funds rate forecast. Source: Federal Reserve.
Such an evolution means that a lot of things are going to change in financial markets.
Implications of Higher Interest Rates
It’s pretty simple, rates go up, asset prices go down. The consequence is less wealth which leads to lower consumption which leads to a recession. This forecast is unpleasant but is also a reality. Hopefully, the economy will be ready for higher rates.
One consequence of higher rates is that mortgage rates will also be higher. Usually, the 30-year fixed mortgage rate is a few percentage points above the federal funds rate. If you do not have a fixed mortgage, or are unable to buy now while rates are low, your future monthly payments will be higher, leaving less money for investments and consumption.
Figure 3: 30-year fixed mortgage rate and federal interest rate. Source: FRED.
Higher mortgage rates might influence a decline in home prices. Figure 4 below shows that declining mortgage costs have supported a continuous rise in home prices.
Figure 4: Home price index and mortgage rates. Source: FRED.
As interest rates go up, so will bond yields. Consequently bond prices must fall. It’s that simple. As bond yields go up, expected stock yields rise as well since stocks are considered riskier and carry a premium. The current expected yield from stocks is around 4% given a PE ratio of 24.85 for the S&P 500. If we add 2% to the expected yield from stocks, we get to 6% which implies a PE ratio of 16.6. Given the current earnings, a PE ratio of 16.6 would mean the S&P 500 would trade at 1447, which is 33% below current values.
In addition to declining asset prices, due to higher expected yields, many corporations have taken advantage of the low rate environment to borrow money. If interest rates go up, financing costs will follow which will lower corporate earnings. Lower corporate earnings means less investments and less investments mean less economic activity. Therefore, the S&P 500 could drop even further.
On a positive note, savers will appreciate higher rates as they have been getting almost nothing for the past 7 years. Higher yields will also benefit Insurance companies that live off of their float and pension funds that are desperate for higher yields.
Is the Above Scenario Possible?
When this scenario begins to play out, investors will get the short end of the stick as higher rates will directly translate into lower asset prices. This shouldn’t come as a big surprise for investors, since the total U.S. net wealth is $80.3 trillion, of which $37.1 trillion is in real estate and $28.7 is in equity. In total, 80% of U.S. wealth is concentrated in assets whose value is strongly correlated to interest rates.
Higher interest rates mean less wealth, less wealth means less consumption and less consumption leads to a recession. Therefore, it will be very difficult for the FED to implement the forecasted interest rate increases without inflicting a lot of pain on U.S. households.
And then there is the issue with the dollar. Higher interest rates mean a stronger dollar, unless Europe and Japan coordinate their rate increases simultaneously. A stronger dollar means less exports and, again, less economic activity.
It’s possible, given the above scenario, that buy and hold investors won’t fare as well as medium term traders and active investors might, since the FED will be forced to see saw back and forth with interest rates. Maybe we will see a rate increase in the coming months, but those rate increases will have a negative effect on the economy and household wealth, and the FED will be forced to lower rates again. The implications of this back and forth rhetoric can already be seen in the 6-month U.S. 10-year treasury note yield chart, where yields have experienced constant up and down movements in relation to nothing more than market sentiment surrounding expectations of higher yields.
Figure 5: U.S. 10-year treasury note yield in the last 6 months. Source: FRED.