AEQUITAS

Lessons to be learned from ris­ing in­ter­est rates

Shares - - CONTENTS - By Russ Mould, in­vest­ment di­rec­tor, AJ Bell

Why US eq­ui­ties seem to be pass­ing the stress test (for now)

Last month’s (26 Sept) in­ter­est rate in­crease from the US Fed­eral Re­serve was the third this year and the eighth for the upcycle that be­gan in De­cem­ber 2015. The head­line Fed Funds rate now stands at 2.25% and the Fed­eral Open Mar­kets Com­mit­tee seems in­tent on one more in­crease this year and three next year, judg­ing by the ‘dot plot’ of the com­mit­tee mem­bers’ fu­ture in­ter­est rate ex­pec­ta­tions.

That would take us to 3.25% by De­cem­ber 2019, the high­est rate since Jan­uary 2008, and this has bond mar­kets un­der­stand­ably rat­tled.

The 2-year US Trea­sury yield has surged from a sum­mer 2016 low of 0.56% to 2.82% and 10-year yields from 1.36% to 3.05%.

This im­me­di­ately begs three ques­tions:

1. Is the bond bull mar­ket over?

2. Is the surge in US Trea­sury yields and in­ter­est rates a threat to the US eco­nomic up­turn?

3. Is the rise in US gov­ern­ment bond yields a threat to the eq­uity bull mar­ket?

BOND MAR­KET BLITZ

US 10-year Trea­suries have fallen in price by 14% since yields bot­tomed (and prices peaked) two-anda-half years ago, in­flict­ing nasty cap­i­tal losses on any­one who bought then.

This col­umn prefers to fo­cus on fun­da­men­tals rather than tech­ni­cal, but chart-watch­ers will tell you that if the US 10-year breaks above 3.05% then yields could go a lot higher still, as that breaks a 35-year-plus down­trend. The 2-year yield al­ready looks to have bro­ken out.

Wage growth is pick­ing up and unem­ploy­ment is low, so the US non-farm pay­rolls and av­er­age monthly earn­ings fig­ure due out on Fri­day 5 Oc­to­ber could be par­tic­u­larly in­flu­en­tial when it comes to Fed pol­icy.

But Trea­sury yields are by no means cer­tain to surge. It may be that the prospect of a 2.8% yield over two years, and around 3.0% over 10, to be banked in the world’s re­serve cur­rency starts to ap­peal to more risk-averse in­vestors (and for that mat­ter pen­sion funds with li­a­bil­i­ties to meet).

In ad­di­tion, data on traders’ deal­ings in fu­tures mar­kets from Amer­ica’s COMEX re­veals that spec­u­la­tive short po­si­tions against US 10-Trea­suries (or bets that yields will rise and prices will fall) al­ready stand at record highs, at some 684,712 con­tracts of $100,000 apiece. This wave of short­selling may, at some stage, turn into a buy­ing spree if and when the shorts de­cide to cover.

EQ­UITY AL­TER­NA­TIVE

In­vestors with sub­stan­tial ex­po­sure to US eq­ui­ties will be won­der­ing what the Fed’s poli­cies mean for them. It is pos­si­ble that the prospect of a 2.8% cer­tain re­turn in dol­lars (in nom­i­nal terms) over two years or 3.05% over 10 starts to look tempt­ing rel­a­tive to riskier stocks (even if eq­ui­ties of­fer greater po­ten­tial cap­i­tal up­side).

Note that the eight post-1970 peaks in the S&P 500 have been pre­ceded by an av­er­age rate rise of just over two per­cent­age points (or 2.75% if you ex­clude 1990 when rates were go­ing down). We are al­ready at 2.25% in this cy­cle, with four more quar­ter-point in­creases pos­si­ble by the end of 2019.

We are there­fore en­ter­ing a del­i­cate phase, although bulls of US stocks will take so­lace from the wide range of rate in­creases over prior cy­cles and how even a 3.25% Fed Funds rate by next Christ­mas would not take us to bor­row­ing cost lev­els that have char­ac­terised prior stock mar­ket peaks.

STRESS TEST

Eq­uity mar­ket ac­ci­dents tend to hap­pen when in­ter­est rates are ris­ing (as now), val­u­a­tions are full (which is de­bat­able) and earn­ings and the econ­omy dis­ap­point. There is no sign of the last-named, thank­fully, but one quick way to check this could be the Chicago Fed’s Na­tional Fi­nan­cial Con­di­tions in­dex and the St. Louis Fed’s Fi­nan­cial Stress in­dex. If ris­ing rates are cre­at­ing prob­lems it should show up in these in­di­ca­tors fairly quickly.

The good news is that nei­ther read­ing has fol­lowed through on a spike in the spring. In the past a score of 0.00 on the Na­tional Fi­nan­cial Con­di­tions in­dex and a read­ing of 1.00 on the St. Louis Fed’s in­di­ca­tor have warned of trou­ble ahead for stocks, com­pared to the lat­est read­ings of -0.87 and -1.29, so there is no sign (yet) of a spill-over from ris­ing rates into the US econ­omy and thus cor­po­rate earn­ings.

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