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It really should not be surprising that there is such a “fear” attached to a bump up in interest rates given the litany of commentary suggesting that the “Great Bond Bull Market” of the last 30-years is over. If you want to read the condensed version of this week’s newsletter, HERE it is:
“Interest rates are not going to significantly rise in the near term to any meaningful degree. In fact, it is very likely that interest rates on Government issued Treasuries will remain range bound between 1% and 4% for the next 20 years.”
Now, you can go back to what you were doing, OR you can read my reasoning as to why I believe this to be the case HERE (below is a snippet of what is included in the article).
The above are edited excerpts (as is the following copy) from an article* by Lance Roberts (StreetTalkLive.com) originally entitled The Interest Rate Conundrum which can be read in its unabridged form HERE.
The Fundamental/Economic Case
There is a very high correlation, not surprisingly, between three economic components (inflation, economic and wage growth) and the level of interest rates.
Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy as illustrated in the chart below.
When the economy is expanding organically
- the demand for capital rises as businesses expand production to meet rising demand,
- increased production leads to higher wages which in turn fosters more aggregate demand and,
- producers have the ability to charge higher prices (inflation) and lenders to increase borrowing costs as consumption increases.
In the current economic environment, however, this is not the case.
- The need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak.
- While employment has increased since the recessionary lows much of that increase has been the absorption of increased population levels.
- Many of those jobs remain centered in lower wage paying and temporary jobs which does not foster higher levels of consumption.
Whether you agree with this premise, or not, is largely irrelevant to this discussion. The current “bullish” mantra is the “great bond bull market is dead, long live the stock market bull.” Is that really the case, though, because when the bond bubble ends bonds will begin to decline in price, potentially rapidly, in turn driving interest rates higher. This is the worst thing that could possible happen for stock bulls because the stock market is ultimately a reflection of economic growth.
For those of you who still doubt that rising rates are bad for stock market returns, let me put the situation into graphical form for you. The chart and table below show what happens to the financial markets, and the economy, when interest rates increase.
The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.
What would be required to diminish the impact of bursting bond market bubble is:
- a slow, and controlled, unwinding of the bond market over an extremely long period of time. The Fed would have to step up interventions on a massive scale to offset the selling of the bond market to curtail the rise in rates.
- Even with that, I would expect a rather sharp economic deceleration as the housing market grinds to halt and overall consumption declines…
However, while bond prices are near historic highs, with interest rates near lows, it would certainly seem as if bonds are in a bubble. However, if interest rates are a reflection of economic growth, inflation and wages, as the first chart above suggests, then rates are likely “fairly valued.”
To learn all about The Technical Case go HERE.
*http://streettalklive.com/index.php/newsletter/current-issue.html
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