Why I'm Calling The Federal Reserve's Bluff

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Includes: EGF, FTT, GOVT, PLW, TAPR
by: Adam Harrington
Summary

Recent claims that the Federal Reserve has a plan to slowly raise interest rates back to stable levels has investors on edge.

The cost to service the U.S. debt at higher interest rates is at an all time high.

The Federal Reserve does not have the ability to raise interest rates of any significant value without crippling the economy.

The Federal Reserve has made public that they are creating a proposal that could be implemented as soon as this summer to start a long term plan to raise interest rates. However, the elephant in the room is whether or not the U.S. can afford to service interest rates at higher rates given the amount of outstanding debt. Many investors saw interest rates rise significantly from 1950 to 1980 and expect history to repeat itself. However, are we truly in the same position we were in in 1950 or are we in completely untested water? This article will show the history of our debt, interest rates, and the cost associated with raising interest rates in each of the last 75 years. Given this information we will have a clear unbiased view of the current situation of U.S. interest rates and the Fed's true ability to raise interest rates in the current state.

Basics of the Bond Market

There are two main factors that affect the price of a bond, yield to maturity and maturity. I graphed bonds three dimensionally to fully understand how prices fluctuate given these two variables. As you can see below, bonds are more sensitive to changes in prices with long maturities and low interest rates.

Graph 1

Next, I found the percent change in price given a half percent increase in interest rates. I used both duration and convexity to plot graph 2. Again, you can see that rates are more sensitive at low interest rates and long maturities.

Graph 2

History of U.S. Debt

Now that we have fresh view of the bond market we can start to analyze the history of U.S. interest rates and the cost associated with a one percent increase in interest rates on U.S. Treasuries. We can start by analyzing the two factors that affect the price sensitivity of the bond (YTM and Maturity). The graph below shows the average interest rate on U.S. debt in each year from 1950 to present time. As you can see, rates rose drastically from 1950 to 1980 and decreased at the roughly the same rate from 1980 to present.

Graph 3

Next we can analyze the average maturity of the debt in each of the last 75 years in order to have an even clearer picture of the history of U.S. debt (as shown below).

Graph 4

Now that we have the two components that affect the price of the bond (YTM and Maturity) we can accurately calculate the sensitivity of the debt in each of the last 75 years using duration and convexity formulas. This graph shows the percent change of a one percent increase in interest rates in each of the last 75 years. As you can see from graphs 3 and 4, the U.S. had the highest interest rates and shortage maturity in the 1970s and 1980s. Therefore, interest rates were far less sensitive in terms of price during this era (Graph 5).

Graph 5

Now, if U.S. Debt was constant for the last 75 years I would say without a doubt that interest rates could rise just as easily as they did from 1950 to 1980 (based on graph 5). However, as you can see in graph 6, the level of debt has risen dramatically and therefore will affect the cost of servicing interest rates at higher rates.

Graph 6

Obviously the more debt there is the more costly it will be to raise interest rates. Furthermore, the sensitivity of the debt given the Maturity and YTM will also greatly affect the cost associated with raising interest rates. Since I have the data shown in the previous two graphs, I was able to calculate the cost of raising interest rates one percent in each of the last 75 years (Graph 7). As you can see, the cost of raising the debt one percent slowly decreased from 1950 to 1980. This makes sense because the debt stayed constant, interest rates rose, and the maturity of the debt decreased significantly. On the other hand, the opposite happened from 1980 to 2015 since interest rates decreased, the length of the maturity increased, and the amount of debt grew significantly.

Conclusion

Based on this simple analysis I truly believe that the U.S. is in completely untested water, and the Federal Reserve does not have the ability to raise interest rates of any significant value without crippling the economy. The Federal Reserve did raise interest rates significantly from 1950 to 1980, but this was a time where the national debt was nine times smaller and as a result, the cost associated with raising interest rates one percent was very minimal. Therefore, comparing the change from 1950 to 1980 to current claims that the Fed will raise interest rates is like comparing apples to oranges. I believe that the Federal Reserve's claims are merely a bluff to appease Congress who has been putting pressure on them to hike up interest rates to gain more stability. However, if interest rates were to rise it would be more costly than ever and would be a major shock to banks, corporations, and our economy as a whole. Based off this information I believe that any rate hike will be very minimal and the years of low interest rates will remain for years to come.

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