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Thoughts On Why Rates Are Rising And Should Continue To Rise Near Term

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Includes: AWTM, BBSA, BIL, CLTL, DFVL, DFVS, DLBL-OLD, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, GBIL, GOVT, GSY, HYDD, IEF, IEI, OPER, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTI, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, USTB, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Jason Tillberg
Summary

Inflation looks to be steady now.

Loan demand appetite may well be back.

Strong real wage gains boosting confidence.

Rates have more room to run.

What's really at stake when an investor lends money at a particular rate of interest is what the rate of inflation will be over the same period of time as the life of the bond.

If the investor believes credit growth is drying up and will be very low, then inflation is likely to be low, and in that case, the investor is willing to lend money at a low rate of interest. A speculator may well want to purchase longer-dated bonds with a fixed rate of interest and hope to profit when rates fall and his or her fixed-rate bond rises in price.

Recently, after almost a full year of rates moving lower, rates have jolted higher.

The 2-year Treasury yield has jolted higher since bottoming on September 4th at 1.43%. As of now, just 8 days later, it trades at 1.77%.

Board of Governors of the Federal Reserve System (US), 2-Year Treasury Constant Maturity Rate [DGS2], retrieved from FRED, Federal Reserve Bank of St. Louis, September 16, 2019.

Longer-term yields have also been jolted higher. The 30-year Treasury was 1.95% on September 3rd and is now trading at 2.32%.

Rising rates have big impacts on bond funds. For example, the iShares 20+ Year Treasury Bond ETF (TLT) has been hit as rates have risen.

Source: BigCharts.com

This bond fund has been recommended as way to invest in a lower-moving interest rates environment. I myself recommended it back in the fall of last year on expectations of lower interest rates and lower inflation.

This trade might well be over for now.

How We Got Here

Since last fall, rates were going down and expectations for the Fed went from hiking rates to lowering them. What greatly impacted that turnaround in expectations was the lower inflation rate and lack of demand for credit.

The lower inflation came from the strong dollar, lower commodity prices, especially food and energy, and lastly, tariffs that failed to prove inflationary due to currency changes to our benefit, inflation-wise. Demand for credit was also showing declines, per the senior loan survey done by the Federal Reserve bank.

Here is a 1-year chart of both inflation and the 5-year inflation expectations. Both have been trending down for most of the year.

Inflation bottomed in the early part of 2019 at 1.50% and has risen only a little and remained steady.

I forecast that inflation will remain steady with a slight bias to the upside for the next 3-12 months. I'll share most of my reasons for that below.

Wage Gains Vs. Inflation

It's tough when you get a raise at work and that raise doesn't even cover the increase in the cost of living. That's what much of the mid-1970s to early 1980s was like.

Of late, wages have ripped ahead of the rate of inflation, and this should continue to boost confidence.

Here is longer chart showing the year-over-year change in production workers' wages in the private sector versus the rate of inflation.

Wages were up 3.46% in August versus an inflation rate of 1.76%.

It should be noted that the recent jump in oil prices will prove to be an inflationary force and will reduce the real wage gains in the coming weeks and, potentially, months ahead.

Loan Demand

Back in August, we got the Senior Loan Survey results from the banks. This survey gives us an indication of loan demand.

Here is the result of the net percent of banks that reported stronger demand for auto loans reported on August 5th.

A net 10.5% of banks reported stronger demand for auto loans for the 3rd quarter of 2019. This was the highest reading since the 4th quarter of 2016.

Then, auto sales had a positive month in August, rising .66% year over year.

Compare this to India, where car sales were down a whopping 41% in August!

There was a huge jump in demand for government mortgage loans:

Credit growth is the greatest contributor to inflation. Seeing demand for loans picking up means that inflation will have some life to it. That life could keep inflation in the range of 1.70-2.00% for the time being.

Certainly, the Federal government running a trillion dollar-plus deficit helps inflation too. Without all this credit growth, inflation would be lower and justify the low interest rates environment we're currently in.

The deficit is up 19% year over year, or $169 billion more, as of the first 11 months of the fiscal year at the Federal level. This increase is money throws another log into the inflationary fire.

Conclusion

Inflation expectations are about right now, meaning no surprises should be coming. I do not forecast any meaningful decline in inflation, nor do I forecast any meaningful increase in inflation at the current time.

The recent shift in loan demand is the tell that rates have bottomed for now and a bounce is in order. Investors might not be so keen now on the potential for lower inflation if there is life in demand for loans.

Any potential for higher inflation makes owning low-yielding debt, especially longer-dated bonds, more prone to declines from the rise in rates. I would be neutral on TLT with a downside bias for the next 1-3 months, as I believe this bounce in rates has more room to go.

Medium term, looking 6 months to 1 year out, the prospect for another leg down in interest rates remains very possible.

A recession could put the brakes on credit growth, and the US dollar remains the strongest and safest currency in the world for now. So, I would not rule out another leg down in interest rates before we see a bottom.

Disclosure: I/we 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.