Lessons to be learned from rising interest rates
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.
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.
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.