Implications Of Rising Interest Rates

Includes: MUB, TLT, XLF
by: Jason Tillberg

2013 has been marked by a wicked rise in interest rates beginning around May.

There has been a good deal of warning about rising interest rates this year too.

FINRA, the Financial Industry Regulatory Authority, issued a warning about rising interest rates to bond investors on February 14th, 2013 in a note titled: "Duration - What An Interest Rates Hike Could Do To Your Portfolio"

Back in May, Fed Chairman Ben Bernanke warned Congress that "A premature tightening of monetary policy could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further."

With all the recently added Federal Debt, some $7 trillion since 2008, it's wishful thinking that rates would only rise "temporarily."

Rising rates have the potential to blow out the State, Local and Federal Budget deficits as debt service payments rise.

Even though we still have no clear indication that the Fed will "taper" its $85 billion per month bond buying program, interest rates remain on a tear, perhaps because of the stronger-than-expected economy in the U.S.

Today's private sector payroll report for July indicated the U.S. economy added 200,00 Vs. expectations of adding 180,000. The first estimate of Q2 GDP was 1.7% vs. expectations of 1.1%. The 10-year Treasury reaction to those stronger-than-expected reports was a spike in yield from 2.62% to 2.69%.

A stronger economy should imply stronger demand for capital as businesses are more willing to take out loans to expand their business. Stronger demand for capital should imply higher rates of interest for that capital.

Looking at total aggregate debt in the U.S., it's about $57 trillion as of Q1 of 2013.

As you can tell from this chart above, the pace of increase looks to be accelerating.

Here is a chart of the year-over-year percent change of total credit market instruments:

Aggregate demand for credit is the strongest it's been since the recession.

According to economist Martin Armstrong, interest rates are set to soar into 2015.75 or October of 2015 and even beyond.

In 1996, he produced this chart and suggested that rates would bottom in 2013 at under 5% and from there, soar into 2015.75.

The basis for such a forecast is the number Pi or 3.14. In this case, it was 31.4 years after rates peaked in or around 1981 depending on the duration of the bond. Looking back at his forecast today, he says:

The Fed bought-in 30 year bonds trying indirectly to support the housing market. They fulfilled the cycle perfectly and now we will see rates rise faster than ever before. Thus, everything is exactly on schedule. 2013 is the turning point in rates.

We have three items here that show concern for rising interest rates:

  1. FINRA warns investors of the implications of rising rates on their bond portfolios.
  2. Bernanke is warning Congress about the risks of premature tapering that would cause interest rates to rise. (Investors believe a stronger economy will increase chances of Fed Tapering)
  3. Martin Armstrong's computer model seems to be correct. His warnings I tend to like to heed.

If the economy is strong and jobs are created, which is what we want to see happen, that would cause interest rates or the cost of money to rise as demand for money rises. Inflation would rise too as aggregate demand for goods and services picks up.

The catch 22 is, now that we've loaded up on debt, especially to foreigners, those rising rates as a result of our strong economy will cause our deficits to blow out as one implication.

Congress was smart enough to ask the Congressional Budget Office (CBO) about the implications of rising interest rates on the Federal Budget back in March.

The CBO responded with data for three different scenarios.

  1. Interest rates rise to their average levels over the 1991-2000 period;
  2. Interest rates rise to their average levels over the 1981-1990 period; and
  3. Interest rates follow a path that is consistent with the average of the 10 highest projections shown in the October 2012 and February 2013 releases of Blue Chip Economic Indicators."

It produced this chart of what the interest rates would look like under the three scenarios Vs. their current baseline:

The cost implications, outside of the current CBO baseline projections of interest rates would be as follows:

For 2013, the baseline forecast was for the 10-year Treasury to yield 1.9% and go to 2.5% in 2014.

As I write, the rate is 2.69%, up 7 basis points from the day before.

Here is a chart of the 10-year Treasury for the past year:

With regards to bonds and bond funds, the longer the time to maturity, the greater the risk to a fall in price if interest rates rise as this is another implication of rising interest rates.

IShares 20 year+ Treasury bond fund (NYSEARCA:TLT) is such an example of a fund that bears great interest rate risk.

(click to enlarge)

Municipal bond funds (NYSEARCA:MUB) have been taking a hit since May as well:

The factors that will ultimately cause interest rates to go higher are inflation and a stronger U.S. economy, which would cause greater demand for credit.

The whole point of lowering interest rates as the Fed did from 2008 and on was to help lower the cost of capital to both lessen the burden of debt service payments and promote investment.

The whole point of the banker bailout and massive Federal Budget deficits was to lessen the painful effects of the recession and prevent a depression. A "Faustian Bargain" we'll soon find out.

Rising rates should also begin to take the default rate on business loans higher. Currently, the delinquency rate on business loans is 1.08% as of Q1 2013. This is well below historical norms and likely on account of the measures from the Fed.

American Banker put out an article by Eugene A. Ludwig in early June titled "Banks Should Heed Bernake's Warning On Interest Rate Risk."

In this article, he writes:

Record profits and rising markets have led to some deserved optimism about the state of the banking industry. But concern is growing about an issue that has worried many for some time: interest rate risk. A long-simmering mix of high liquidity and low interest rates could spell trouble for many banks, consumers and businesses.

Regulators have said they consider interest rate spikes to be a risk with systemic implications. Federal Reserve Chairman Ben Bernanke told Congress that the dangers of rising rates are a major consideration in the Fed's withdrawal from the open market.

Investors really need to be careful in this environment. Long-term debt securities and high risk bond securities are likely to be the most at risk on account of a continued spike in long-term interest rates. Bank Stocks (NYSEARCA:XLF) are also at risk in this environment of spiking interest rates as per the warnings of Eugene A. Ludwig.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.