Why you shouldn’t fear rising rates
We’re in better shape than doomers think
Will rising long-term interest rates impale your future? A poll of financial professionals shows they think rates will keep rising, believing the Federal Reserve’s hikes will push long rates up. But that isn’t how it works. I learned very young that any forecast professionals agree on is exactly what is already prepriced into markets.
The good news is bond rates will remain tame. The bad news? Don’t hope for high bond returns anytime soon. Whether mortgage rates, corporate bonds or tax-free municipals, they all wiggle based off gyrations in the 10-Year U.S. Treasury rate. And those rose almost a half-percent this year to
2.96% (peaking May 15 at
3.12%). They’re now around the level of Feb. 21.
A previous column touched on what mostly drives long rates: variations in inflation expectations. Most pundits misunderstand inflation, thinking it comes from low unemployment and rising wages. No. A November column explained it comes from fast-rising money supply. Too much money chasing too few goods and services. If the broad quantity of money doesn’t grow far faster than our economy, we don’t get intensifying inflation — or long rates.
First consider the “real” rate — what lenders require to be “compensated” for forgoing cash long term, except for inflation’s effect. It hardly wiggles, except in a crisis, and approximates GDP’s “real” growth rate (roughly 2.5%). There is also an “inflation premium” on top of that real rate, needed to compensate lenders’ collective future inflation fears. That portion wiggles wildly as inflation expectations gyrate. It’s most of the variation in the combined rate. Without real escalating inflation, which requires excess money growth, inflation expectations can’t wiggle far.
To see if money supply is jumping or slumping, first note what money is. Bank deposits, short-term commercial loans, Treasury bills, money-market accounts — everything of stable value, broadly exchanged and liquidated easily, fast. It’s officially called “M4”, the broadest money measure. M4 grew 4.6% in the year through April, slower than most of 2016 — when inflation flat-lined.
M4 is overwhelmingly created solely via bank lending — when the banking system increases net outstanding loans. Zooming M4 requires booming bank lending.
Here is the trick. Banks use short-term deposits as the foundation to finance longterm loans. The amount longterm rates exceed short-term rates determines future banking profitability from lending — their profit spread and basic motivation to lend. The bigger that spread, the more they lend. And vice versa. When the Federal Reserve raises shortterm rates, it shrinks that profitability. So bank lending slows,
M4 growth slows and inflation slows. And long rates bounce around — going nowhere fast.
The more short rates are hiked, the more long rates won’t rise — or may fall. What matters most is global money supply, inflation expectations and long-to-short rate spreads. But global rate spreads have fallen slightly since last year. Hence global lending and money supply have grown modestly. America’s M4 growth likely parallels that global reality. So there’s no escalating inflation.
Worldwide, folks are wrong on long-rates regularly. Read stories on Italy’s political gyrations and supposedly catastrophic debt. But it works there like everywhere, basically. If Italy’s debt truly were problematic, wouldn’t its 10year yields be miles above ours? But as I write, they’re basically identical. Why? Modest money growth. And, as I detailed in Il Sole 24 Ore, Italy’s top business paper, the country’s debt is in its best shape in decades — and manageable.
Still, when Italy can borrow as cheaply as America, the world must be in vastly better shape than rate-doomers deduce. And fear of a false factor is always bullish. Fears don’t get much more false than today’s rising-rate phobia.