Rising Interest Rates and its Effects

2/25/2018 – After nearly a decade of speculation, interest rates have finally began to increase as inflation has started to pick up (about time). The impact of rising interest is far from certain, but I put together a simplified flowchart to help illustrate the effect (see below).

For the past 40 years, the bond market has been in a near-perpetual bull market. Though, that bull market run has seemed to have faltered lately with the 10-year Treasury rate increasing to 2.92%.

LT 10-Yr Treasury

That might not seem like much. but on a relative basis, an increase in yield from 1.37% to 2.92% means a significant drop in what is widely considered a “safe” investment.

IEF: 7-10 Yr Treasury Bond Performance

Interest rates (partially due to increasing inflation) are rising and nobody seems to really care. This, of course, seems to make sense as recent equity performance has been stellar and those gains have overshadowed bond losses. Though, ignorance can’t continue forever and higher interest rates will at some point have a greater impact. (Note, this is NOT an argument to short Treasuries or to place any other short-term bets. See here for proof that active trading rarely pans out.)

IEF & TLT: Higher Interest Rates
IEF & TLT: 6 mos performance

So, there are really two questions that we need to ask ourselves:

  1. How high will interest rates rise?
  2. What will happen as a result?

Of course, economic forecasts are famously inaccurate. Making a forecast, such as, “I believe the 10-year Treasury rate will jump as high as 4.00% before scaling back.” is just as likely as saying, “The 10-year Treasury rate will fall to 2.00% before jumping back up.” Each forecast is just as likely as the other.

Nonetheless, higher interest rates do pose a risk to equity prices. The higher interest rates go, the more attractive bonds become. Especially if uncertainty rises. Remember, equities are risk securities – many individuals seemed to have forgotten this recently. When volatility picks back up, uncertainty will rise and individuals will look to put their capital into something safer. If the 10-year yield is at 4.00%, those individuals are more likely to purchase a guaranteed 4.00% bond.

This is part of the natural equilibrium of a functioning economy. There are plenty of other consequences of rising rates, including reduced consumption, an appreciating USD, but the end result is typically lower inflation and economic growth.

So, should we be panicking right now? No. Interest rates have not been rising at an alarming rate. Typically, rising interest rates coincide with a strong economy, which seems to be the case this time. Unemployment is near historic lows, corporate earnings growth continues to impress, and with tax reform as a tailwind, the near-term economic outlook is still good. Though, with U.S. equity valuations as high as they are, it doesn’t hurt to be sensible with your money by not ignoring the grave mistake of disregarding risk management.

Ryan Hughes
Bull Oak Capital
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