Interest Rates are Trending Up. So What?

September 6, 2013

If you haven’t already, you will soon be hearing alarming reports of the “dramatic rise of Treasury bond rates” that this will have a disastrous effect on bond owners and the economy in general.  Higher interest rates!  More inflation!  Lower economic growth! More competition for the stock market, and therefore lower stock prices!

If you look at the recent rise in 10-year Treasury rates in isolation it does indeed look remarkable: a rise of more than 70% from a May 2 low of 1.63% to somewhere in the neighborhood of 2.90% as you read this.  But if you put the recent rate rise into a longer-term perspective the recent “dramatic rise” looks awfully puny compared with some of the long-term swings in market history.  The high percentage shift is more a reflection of how low rates had gotten than a rise to dramatic heights.

So what’s really going on here?  Nobody knows when the Federal Reserve Board is going to stop buying Treasuries.  The Fed’s most recent meeting minutes suggest that it will be cautious about winding down its QE bond buying program.  But that still leaves a bit of uncertainty about where rates will go.

All professional investors know for sure is that when a big buyer, like the Fed, walks away from the marketplace there will be less demand for whatever they were buying than there was before. Therefore bond issuers–including the U.S.–will have to pay more (i.e., higher yields) to lure in the fewer remaining buyers.

Right now, inflation is pretty low, in part because the high joblessness rate is making it harder for workers to ask for huge raises, in part because the banks have a lot of money to lend and not a lot of people asking to borrow it.  A recent report notes that an astonishing 82% of the U.S. money supply is currently on deposit at the Fed, mostly in accounts held by large banks.  (To put that in perspective, the average percentage from January 1959 through the end of 2007 was 6.18%.)

About the only thing we know about the Fed’s decision-making process, from its notes and internal policy debates, is that it is only going to start exiting its QE program when it thinks the economy is healthy.  If the stock market starts to look edgy, or the U.S. starts sliding back into recession, you can bet that the Fed will want to keep interest rates low and be a tad more gradual about ending its QE activity.

If you add up all these factors, you come out with something very different from the disaster scenarios you’ll be hearing in the news.  The Fed is planning to stop buying Treasuries at some point in the future, and let market forces take over–but only when it feels like the economy is healthy, and only so long as it can do this without harming economic growth or hammering the stock market.  So what we’re seeing in the bond market appears to be nothing catastrophic if you can step back from the media headlines and take a look at reality.

Article written by Bob Veres of Inside Information

Sources:

http://seekingalpha.com/article/1657072-how-high-are-yields-likely-to-rise?source=google_news

http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=10_YEAR&insttype=Bond

http://www.minyanville.com/trading-and-investing/fixed-income/articles/What-if-the-10-Year-Treasury/8/26/2013/id/51458

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