August 2016 – Monthly Commentary
August 2016
With the Federal Open Market Committee scheduled to meet on September 21st, investors find themselves debating, yet again, whether or not the Fed will raise short term interest rates. Recall, we were in a similar situation exactly one year ago. Chair Yellen’s comments at last month’s Jackson Hole, Wyoming gathering of Central Bankers were interpreted as being mildly hawkish just as they were last summer, and the markets reacted accordingly.
The yield-to-maturity of the 30-year Treasury bond has moved sharply higher during the first two weeks of September, and stocks, while trading just shy of an all-time high, are also under selling pressure; as they were a year ago. The selling pressure has been exacerbated as a number of long term bond bulls changed their opinion during the month and now view current interest rates as too low. We’ve been of that opinion for some time now. Core inflation year-over-year, the measure the Fed has historically cited as their preferred measure, has traded in excess of 2.0% every month this year, and is averaging 2.3% for the last 3 months. With inflation climbing at that rate the 1.7% yield offered by the ten year note results in the investor losing 0.50% of buying power per year. That means that a $1,000 investment would only buy $994.88 of goods and services when the note matures in ten years. Under normal circumstances, with that level of inflation, the yield on the 10-year note would be approximately 3.5%. Instead, by keeping short term interest rates at the emergency, near zero level, the Fed is forcing investors to seek higher rates by investing in riskier investments to overcome the loss of purchasing power. To accomplish that, investors are investing in lower credit quality debt and/or extending the maturity of their investment portfolio, both of which mean greater risk. That heightened risk appetite has caused the yield differential between overnight interest rates and the 30-year bond to compress, known as yield curve flattening. The problem with that is the 30-year bond’s sensitivity to interest rate movements is 2.3 times greater than that of the 10-year note. To put that into risk terms, should interest rates rise by a mere 1.0%, the price of the 10-year note would lose 9.2% of value; not a very attractive outcome. However, under the same rate rise scenario, the 30-year bond would lose 21.4% of its value. In the most basic terms, to increase investment yield by 0.67% by replacing 10 year notes with 30 year notes, investors are assuming enormous risk. However, the average investor is unaware of the sensitivity of bond prices and is simply desperate for additional income. The paradox is that the Fed worries that a rate rise may slow economic activity, as borrowing cost go up and consumers pull back from consumption. Equity investors would likely view a rate hike unfavorably, and a short term correction could possibly ensue. But it’s unlikely that a recession would follow. On the other hand, if the economic fundamentals improved to the degree that inflation begins to trend materially above the Fed’s 2% target, the Fed would be forced to raise rates at a more rapid pace or risk an overheating economy. In that scenario, investors would dump bonds, and given the heightened risk sensitivity explained above, would realize large losses in their historically stable portfolio. With interest rates so low, the price drop could be steep, and given the aggregate size of the bond market, that could cause a recession.
Arguably, we are in the middle innings of the rising inflation scenario, but the Federal Reserve continues to hold interest rates close to zero. Some on the FOMC have become quite vocal in calling for the committee to deflate some of the bond market bubble by raising the Fed Funds rate at the September meeting. However, that is not a unanimous opinion and those favoring keeping rates lower for longer have been equally vocal. If history is any guide, the Fed will stand pat next week and talk will shift to whether the Fed will raise rates in December, just as they did last year. But then again, that rate hike wreaked havoc with the stock market in the weeks that followed, so maybe they’ll skip that one as well.