Economic Effect Of Higher Rates

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The president-elect's policies boosted growth and inflation expectations, and also brought about remarkable surge in optimism.

If perception becomes reality, higher growth may offset the impact of higher interest rates.

I reiterate my short-duration recommendations to active bond investors, and give initial market outlook for 2017.

Credit drives consumption in our finance-based economy. Interest rates rose sharply this quarter, with the 10-year Treasury yield at 2.58%, the highest in about two years. Most borrowing rates, including mortgages, car loans, etc., also jumped in tandem with respective Treasury yields. For example, the average 30-year mortgage rate at 4.16% is now the highest since October 2014 (see chart). While most economists would expect significantly negative effect of higher borrowing costs, here's what we see so far.

Sources: MBA, Freddie Mac, Model Capital Management LLC

Mortgage applications dropped in the past two months, but not as sharply as feared. During the "taper tantrum" period in May-Aug 2013 when mortgage rate jumped by 1%, applications fell by a cumulative 53%. Today, they have declined by a cumulative 27%. More may be forthcoming depending on future path of rates, but the damage has been limited so far.

Shorter Treasury yields jumped even more than long-term rates in relative terms. The five-year Treasury rate at 2.07% is now the highest since 2011. Yet, auto sales continue at robust rates: 17.87 million vehicles sold in November (at annual rate), near the top of 2016 range.

The rise in interest rates, which began based on market forces, accelerated by the election of Donald Trump. The President-elect's policies boosted growth and inflation expectations, and also brought about tremendous surge in optimism.

Consumer sentiment measures surged since November. The University of Michigan consumer sentiment index rose to 98 in December near the highest in 10 years. The Conference Board's consumer confidence also jumped to 107.1, the highest since 2007.

Source: National Federation of Independent Business

Small business optimism also jumped to 98.4, near the top of its 10-year range.

There are two ways of thinking about the recent jump in interest rates. Higher interest rates dampen economic activity, other things equal. But other things are not equal - higher growth tends to drive up inflation, inflation expectations, and interest rates. In our economy, perception is largely reality; rising sentiment tends to drive rising economic activity. What kind of growth we get in the coming months remains to be seen, but post-election surge in sentiment has been nothing short of remarkable.

What It Means To Bond Investors

In my Dec-5th article when the 10-year Treasury was at 2.4%, I wrote: "The rise in yields brought them closer to attractive levels, but not there yet." Rates jumped after the Fed's December meeting on higher outlook for future path of inflation and interest rates. The 10-year Treasury currently trades around 2.6%, the highest since October 2014.

Here is performance for popular bond index ETFs since June 30th.

  • Barclays U.S. Aggregate bond index (AGG, BND): -3.5%
  • Treasury Inflation-Protected Bonds (TIP, SCHP): -2.9%
  • iShares Investment-Grade Corporate Bonds (LQD): -3.9%
  • Long-Term Corporate Bonds (BLV, VCLT): -5% to -8.4%
  • iShares 7-10 year Treasury index (NYSEARCA:IEF): -7.2%
  • Long Treasury bonds (TLT, TLO, VGLT): -14%

My recommendation to active fixed income investors (that is, those not satisfied with buy-and-hold approach) continues to be: maintain short duration. Avoiding interest rate exposure altogether in floating rate notes (FLOT, FLRN) paid off for us by not losing in the past two months. At this point, 2-3 year corporate bonds (such as SCPB, VCSH) became more attractive. As before, all these are defensive positions. There will be a time to reach out for yield, but not yet.

What's in store for bond investors in the new year? Inflation pressures will likely intensify in the first quarter of 2017. The "Trump bump" in confidence, higher interest rates and inflation will continue supporting asset flows from bonds into stocks. The rising dollar and global geopolitical concerns will encourage flows from global to U.S. assets. I will cover our market outlook for 2017 more broadly in the next article, so stay tuned, and Happy Holidays!

Disclosure: I am/we are long FLOT, FLRN.

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.

Additional disclosure: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.

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