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  • Rising Rates: Later Rather Than Sooner 0 comments
    Mar 15, 2013 1:11 PM

    "…rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.''

    - Alan Greenspan

    It's certainly not news that interest rates throughout much of the developed world remain near historically low levels. And yields aren't just low. They are also significantly below equilibrium rates - the level where rates should be, given normal fiscal and monetary factors. These factors include a global economy that continues to mend, albeit slowly, along with money printing (Quantitative Easing) by central banks around the world that is likely to be inflationary at some point.

    The slowly improving global economy should put upward pressure on real interest rates. Quantitative Easing and similar measures by other central banks should put upward pressure on nominal interest rates (the inflation premium on top of real interest rates). So with rates historically low, and arguably lower than they should be, isn't it obvious that yields have to go up significantly? Not necessarily.

    Fed on hold

    For starters, the Fed is likely to be on hold for some time. It has targeted 6.5% unemployment and/or 2.5% inflation as inflection points to begin withdrawing monetary stimulus. Also, despite some dissent, it is likely that the FOMC will remain "behind the curve" in terms of allowing more inflation when it does finally arrive.

    While everyone seems to agree that rates are going higher, it's not clear which fundamental factors are likely to drive this change:

    Ø Tighter monetary policy from central bankers? Not likely any time soon.

    Ø Higher real interest rates driven by strong global growth? Not likely with the U.S. in a sub-2% GDP quagmire (-0.1% for Q4) and Europe still in recession.

    Ø Higher inflation rates from Quantitative Easing? Not likely given little organic demand, high unemployment (i.e., minimal wage inflation) and the fact that most of the money that's been printed remains on bank balance sheets rather than sloshing around in the economy.

    So while interest rates are low - probably too low - it's no slam dunk that they're going up soon, or significantly. Herein lies the irony of the Greenspan quote above. He offered this warning in 2004 - over eight years ago -when the U.S. 10-Year Treasury was still near 4%. Apparently rising interest rates are not as "obvious" as we think. Just ask the Japanese. Their 10-year yield has been below 2% for over 15 years.

    To be sure, interest rates are going to rise at some point. However this sell-off in bonds may not be as imminent as some portray. The yield curve remains relatively steep, so the cost of simply shortening duration and accepting lower yield is fairly high. Moving money from bonds to cash to avoid the "bond bubble" is a costly waiting game. This leaves investors with a poor set of choices when rates do eventually climb:

    1. Stay in bonds and incur losses
    2. Sell bonds and move into much more volatile equity assets
    3. Sell bonds, move to cash and incur the opportunity cost of lower (near 0%) yields

    But these aren't the only choices. In fact, there are some steps investors can take to maintain a fixed income allocation while mitigating interest rate risk and generating a level of income. More detail on that in my next column.

    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. I have no business relationship with any company whose stock is mentioned in this article.

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