nterest rates on the 10-year treasury have jumped 70 basis points in recent weeks to about 1.58%. That represents a full 1 percentage point increase from the 0.54% low of last summer (See chart below). Higher rates have unsettled equity markets, with high flying technology stocks being particularly hard hit.
We believe rising interest is purely a function of improving expectations for economic growth.
Furthermore, the Federal Reserve is unlikely to allow interest rates to rise to a level that would endanger government finances or the economic recovery. For equity investors, modestly higher rates can be more than offset by faster earnings growth. Bond investors, on the other hand, are likely to experience significant losses relative to inflation over the coming year.
The interest rate for ultra-high quality bonds like US Treasury bonds has two components, a “real” yield and an inflation premium. The real yield is largely a function of expected economic growth. The Treasury issues bonds that automatically compensate investors for inflation (Treasury Inflation Protected Securities, or “TIPS”), so the yield on these bonds is a direct measure of real yields.
As shown in chart below, the yield on longer maturity TIPS has gone up more than the yield on traditional Treasury bonds. That means that all the recent increase in interest rates is accounted for by higher expected economic growth.
Since the bond market selloff began, several market analysts have fretted that the Fed is losing control over interest rates. We think such fears dramatically underestimate the power of central banks.
The Fed explicitly sets short interest rates, and so can clearly keep short rates at zero for as long as they please. However, central banks can also control long interest rates. They do so by altering the amount of money they print and the quantity of long maturity bonds they purchase with that printed money.
Australia’s central bank increased purchases of long maturity bonds in recent weeks. Australian yields plummeted despite increases in most other bond markets. Similarly, the Bank of Japan committed to buying more Japanese Government Bonds (JGB) by refusing to widen its targeted trading band. The Japanese bond market rallied while other global bond markets were selling off. Whenever the Fed decides to do so, it can drive long interest rates down by accelerating its pace of long maturity bond purchases.
The question is not whether the Fed can drive down rates, but rather how high the Fed will allow rates to rise before stepping in and preventing further increases. Rising rates have a negative impact on both the overall economy and the ability of the US government to finance its staggering debt load. Based on historical experience, we believe that the Fed will prevent 10-year treasury rates from rising above about 2%. This would represent about a 43 basis point increase above current rate levels.
The combination $1.5 to $2.0 trillion structural budget deficits and a series of multi-trillion dollar COVID stimulus packages have pushed US debt to well over the size of the US economy. The last time the US was so indebted was after World War II (see chart below). To help the Treasury finance such a huge debt burden, during the 1940s the Federal Reserve enforced a ceiling on interest rates. Whenever treasury rates exceeded the Fed’s targeted cap, the Fed printed money and purchased bonds until rates went back down.
We believe the Fed will need to reintroduce similar caps on interest rates to help manage a similar level of US government debt. If we are correct, then we would expect the Fed to accelerate bond purchases whenever the 10-year treasury yield exceeds about 2%.
A 2% 10-year treasury would clearly represent a significant increase from the historic lows seen during the COVID pandemic. However, the 10-year treasury has traded above 2% for much of the past decade. The dramatic rise in equity and home prices seen over that period should reassure investors that stock and home prices can continue to increase if rates rise to that level. We believe a much stronger economy, fueled by another $1.9 trillion in fiscal stimulus, can more than offset the negative effects of higher rates.
Investors may worry that inflation could surprise to the upside. Higher inflation could force the Fed to let rates keep rising despite potential harm to the economy and US government finances. Fed Chairman Powell made clear in recent Congressional testimony that he is expecting a sharp rise in inflation over the next few months.
The COVID lockdown of last spring caused prices across the economy to drop sharply. Prices have since recovered and in some cases have moved much higher. The comparison of current prices with prices from the pandemic lows of last spring will likely produce a big increase in year over year inflation.
Chairman Powell stated before Congress that he will ignore this expected spike in inflation. Prices plunged temporarily due to COVID and the Fed believes the subsequent surge in prices will prove equally temporary. In addition, the Fed has switched to targeting an average rate of inflation instead of an explicit 2% target. Under the old policy, the Fed would start tightening whenever inflation rose above 2%.
By targeting an average inflation rate, the Fed can let inflation rise above its targeted level until the average inflation rate exceeds 2%. Since inflation has been below this level for most of the past decade (see chart below), the new policy could allow the Fed to let inflation rise above 2% for years before needing to raise interest rates.
Investors in both stocks and bonds have endured losses in recent weeks as interest rates increased. However, we think the Fed has the capability and the policy flexibility to keep rates from moving much higher. The fiscal health of the US Treasury may force the Fed to exercise that power and policy flexibility before rates rise much higher.
We believe that equity markets have experienced a healthy pullback that sets the stage for future gains. Rate increases have been driven by improved expectations for the economy. That suggests the headwind of higher rates will be offset by faster earnings growth as the economy strengthens.
Further support for equity markets will come from additional injections of printed money, in our opinion. The Fed has pledged to keep printing $120 billion per month and buying US Treasury and mortgage obligations.
In addition to this newly printed money, the Treasury will soon draw down its $1.5 trillion on deposit with the Fed. This massive liquidity reserve was created in 2020 as the Fed printed money faster than the Treasury could spend it. Congress just passed another $1.9 trillion COVID stimulus package. As a result, the Treasury will soon spend this money and another trillion dollar wave of printed money will hit financial markets.
Although we believe the outlook is bright for equity investors, we think bond investors could continue to experience losses. Year to date, longer term treasury bonds have fallen between 8% and 12% depending upon maturity. Losses on 30-year bonds could exceed 20% if rates rise as we expect.
Losses relative to inflation will be more severe than these nominal losses. Equity investments have historically outperformed inflation (eventually) because earnings tend to rise with prices. By contrast, the anticipated 2021 spike in inflation is likely to be a permanent loss for investors in traditional fixed rate bonds.
