• Doug Lagerstrom

Market Outlook | Spring 2018

What will happen when interest rates finally go back up? Will our economy be strong enough to survive? Will the stock market crash? Will our government be able to afford the interest payments on our debt? These and other questions have been asked, and debated for over the past 10 years.

While still historically low, interest rates have FINALLY increased and are likely headed higher. The 10 year US treasury bond was yielding 1.37% less than 2 years ago. It yielded 2.07% less than one year ago and recently topped 3% and is 3.05% as of this writing.*


Putting pressure on bond prices, and subsequently causing rates to increase is:


1. The strong US economy

2. The Federal Reserve Board’s (FRB) balance sheet Strong US Economy The US economy is slated to grow in excess of 3% this year for the first time since the 2018 recession. That increased economic activity increases the demand for loans, which causes rates to rise.


Additionally, this stronger economy leads to fears of inflation causing the lenders (bond buyers and banks) to demand higher interest rates. This supply/demand imbalance leads to higher rates.


FRB Balance Sheet

In the wake of our financial crisis, with the federal funds rate near zero, the FRB undertook a new strategy called quantitative easing. In the past, the FRB would set short term interest rates by raising and lowering the rate at which they lend money to banks and fixing the rate at which banks lend to each other. The longer term rates (like the 10 year US treasury bond) that govern mortgages and typically business loans, are set by market forces. The real target of FRB policy is this 10 year US treasury rate.


Rather than decrease the federal funds rate and hope that longer term rates drop too, the FRB undertook the aggressive unprecedented and controversial step of purchasing 10 year US treasury bonds on the market to keep interest rates low. On November 3, 2010 the Fed announced they would purchase $75 billion of longer term US Treasury securities up to a total of $600 billion. They stopped buying in June of 2011. Well now that the economy is on relatively sound footing, the FRB is beginning to sell off its holdings. In the 2nd quarter of last year the FRB sold $18 billion of these bonds. That number increased recently to $30 billion by the fourth quarter. This increased supply on the market is also driving prices lower and rates higher.


Other Fears

So, why aren’t US rates higher? As the global economic recovery continues to trail the US economic recovery, their return to more normalized interest rates is following ours as well. Germany is paying 0.65%, Switzerland is nearly negative and Great Britain is weighing in at 1.15%. Global investors are choosing US rates at 3% over the local ones that are substantially lower. Recently, Italian government debt has been in the news. The politicians recently elected in Italy favor increased government spending on welfare and infrastructure and cutting taxes. They propose to pay their debts with IOU’s!


They are not the only government running up record levels of debt. According to the Bank for International Settlement, total non financial private and public debt amounts to almost 245% of global GDP, up from 210% before the financial crisis and 190% at the end of 2001. Fiscal responsibility is so last century!


Conclusion

Economics is about tradeoffs. Higher rates benefit some at the expense of others. In the case of higher US rates, savers, investors and pension funds benefit from having a more attractive investment option. Home buyers, car buyers, bondholders and stockholders may be unhappy about the higher interest rates. The good news is the FRB will now have some tools to help deal with the next economic crisis. When rates are zero, or close to it, the FRB options are more limited. So embrace it savers, and pension funds, and deal with it first time home buyers.


*Source: Federal Reserve H.15


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