Why Interest Rates Aren't Too High

by: Clif Droke
Summary

Calls for the Fed to lower rates are unjustified.

Stock and bond markets aren't worried about high interest rates.

Market's resilience in face of higher fed funds rate is a promising sign.

While most investors are relieved at the Federal Reserve's latest decision to keep interest rates unchanged, a number of observers feel that rates should be lowered. The argument for lowering rates is based on the observation that the current effective federal funds rate of 2.45% is too close for comfort to the 2.50% current yield on the U.S. 10-year Treasury bond.

Given that T-bond yields have been declining of late, there is a threat that bond yields will soon be lower than the fed funds rate, which critics fear would (if it persists long enough) result in a tight situation for the financial market. In today's report, we'll discuss the argument that the Fed should lower interest rates in order to prevent a financial market setback. While a lower fed fund rate certainly wouldn't hurt the economy, I'll argue that it's unnecessary for the Fed to lower rates at this time. I'll also argue that Treasury bond yields should rebound in the coming weeks based on the latest improvements seen in the U.S. economy. This has bullish implications for stock market investors.

The Federal Reserve kept interest rates unchanged at its latest policy meeting on Wednesday. This was much to the market's satisfaction, though not everyone agrees the fed funds rate is where it needs to be. One of the Fed's biggest critics right now is President Trump who has stated his belief that the Fed is keeping rates too high. To be exact, he has called on the Fed to lower rates by a full percentage point and enact other measures designed to stimulate the economy.

Fed President Jerome Powell disagrees, however, and thinks President Trump is overstating his demands. In his latest policy statement, Powell said there is no convincing reason for a rate cut given current low levels of inflation. He also cited a strong labor market and evidence that economic activity is increasing at a "solid rate" as reasons for not lowering interest rates.

Is President Trump correct that the fund's rate is too high? At 2.45%, the effective federal funds rate is at its highest level in four years and distressingly close to the level of the 10-year Treasury yield. It's interesting to consider that it took only the Fed's assurance earlier this year that it would hold off on rate increases to soothe investors' nerves. Since January, the financial press has commonly referred to this "Fed pivot" as a dovish move when, in fact, it represents only a temporary cessation of its 4-year rate hiking campaign. There was no decline in the fed funds rate at all, and in fact, the effective rate has even increased slightly in recent weeks.

The current fed funds rate is shown in relation to the 10-year Treasury yield in the graph below. As you can see, the last time the effective fed funds rate exceeded the 10-year yield was back in 2007, just prior to the credit crisis. This is by no means to suggest that a similar storm is brewing. In fact, the opposite set of financial market conditions (i.e. bullish) exist today compared to 2007. But the point of the Fed's critics is well taken that, compared to government bond yields, the fed funds rate is getting uncomfortably "high."

Effective Federal Funds Rate vs. 10-Year Treasury Yield

Source: St. Louis Fed

Investors are nevertheless satisfied with the Fed merely remaining neutral. There seems to be a consensus that consumers' balance sheets have improved to such an extent that current rates are desirable. Higher rates suggest that the U.S. economy is strong enough to withstand the higher rates, which was far from being the case in the years prior to 2017. And while Treasury yields are declining, it should be noted that one of the most important barometers of whether or not the Fed is too tight - namely the junk bond market - is flashing a positive message for stock investors.

Shown here is the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), which many investors use as a proxy for aggregate junk bond prices. Prior to the last financial crisis, which was exacerbated by the Fed's excessive hiking of interest rates, junk bond prices were plunging as the market for high-yield corporate debt warned of major problems beneath the market's surface. That's clearly not the case now, as the latest JNK chart attests. Indeed, the corporate bond market is humming along right now at a brisk pace which shows that forward-thinking investors don't believe interest rates are too high.

SPDR Bloomberg Barclays High Yield Bond ETF

Source: BigCharts

Moreover, in recent years, whenever Wall Street feared that interest rates were too high, there has always been a sharp increase in the number of rate-sensitive securities showing up on the NYSE new 52-week lows list. This has historically served as a "heads-up" warning that the stock market was in for stormy seas ahead, including most recently last summer. Today, by contrast, there are a number of rate-sensitive securities, including muni-bond funds and real estate equities, making new 52-week highs. On May 1, for instance, a sizable number of the 206 new 52-week highs on the Big Board were income funds. That's a strong indication the market doesn't believe rates are too high.

Earlier this week, the Commerce Department revealed that U.S. consumer spending increased at its highest rate in nearly 10 years in March. Big ticket items such as automobiles were heavily purchased in March by consumers in a sign that the economy is rebounding from its soft patch earlier this year. Significantly, the Commerce Department also noted that inflation pressures are virtually nonexistent. The lack of inflation is a definite confirmation that rates aren't too high.

Meanwhile, the CBOE 10-Year Treasury Note Yield Index (TNX) after declining for the last few months is trying to reverse its downward trend. Based on the substantial improvements to the economy in recent months, investors will eventually shake off their apprehensions about growth and shed their risk aversion. That means that T-bonds will eventually be sold as investors move more and more into equities. This, in turn, means we can likely expect to see a gradual increase in the 10-year Treasury yield in the coming months. Far from being a cause for concern, higher Treasury yields would be a welcome sign that economic confidence is rising. It will also relieve fears that the fed funds rate is too high relative to bond yields.

CBOE 10-Year Treasury Note Yield Index

Source: BigCharts

With the internal condition of the U.S. equity market still healthy based on the increasing number of NYSE stocks making new 52-week highs, participants shouldn't fear that interest rates are a problem for the stock market. As we've discussed here, more than one aspect of the bond market suggests that the U.S. financial market remains healthy and that informed investors don't foresee a major setback anytime soon. Accordingly, investors are justified in maintaining a bullish stance on equities.

On a strategic note, traders can maintain a long position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ). I suggest raising the stop-loss to slightly under the $31.70 level for this ETF trading position on an intraday basis. Only if this level is violated will I move to a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamental sound stocks in the top-performing industrial, consumer staples, and financial sectors.

Disclosure: I am/we are long SPHQ, XLF. 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.