Submitted by Lance Roberts via STA Wealth Management,
After several months of quite complacency, investors were woken up Thursday by a sharp sell off driven by concerns over potential rising inflationary pressures, rising credit default risk and weak undertones to the economic data flows. One of the primary threats that has been readily dismissed by most analysts is the impact from rising interest rates. Last week, the following chart was circulated again which shows that stocks perform well during rising interest rate environments:
Now, this is surely clear evidence that one would want to be long stocks during a rising interest rate environment, right? Not so fast. There are a couple of important points you may want to consider before jumping on the bandwagon. First, let's look at the specific periods analyzed. 1993-2000 was the massive "technology" driven boom which covers the entire first half of the chart. 2003-2006 was the majority of the real estate/liquidity bubble while the last two periods were during a Fed induced liquidity push. In otherwords, there is little "normalcy" during this entire period.
However, more importantly, is not what happened DURING the periods of rising rates, but rather what happened following those periods. Those mysterious dashed vertical lines on the chart above represent what is NOT being shown to you. For clarity purposes, we need to look at the entire data series to see what the actual impact of rising rates on the financial markets has been. I have highlighted peaks in interest rate increases and corresponding events.
The issue with rising interest rates is that higher borrowing costs lead to slower economic activity and a quelling of inflationary pressures. The Federal Reserve believes they can control the economic engine by using monetary policy as a governor. This is kind of like playing "Jango" where the object is to weaken the structure by removing supports without toppling it entirely. Of course, like the actual game, the Federal Reserve's track record of successfully managing the economy is "poor" at best.
This weekend's reading list is a set of viewpoints on the Federal Reserve and the potential impacts from an increase in interest rates.
1) Rising Rates: The Good, The Bad…No Ugly by Doug Peebles and Ivan Rudolph-Shabinsky via Pragmatic Capitalist
[Note: This piece is really specifically talking about individual bonds versus bond funds. Bond funds do not mature and are strictly a play on the direction and trend of interest rates. This is an important distinction and a primary reason why I continue to suggest owning bonds in portfolios, rather than bond funds, which reduce portfolio risk and volatility, provide principal conservation and an income stream.]
"By their nature, bonds are generally sensitive to interest-rate movements—when rates rise, prices typically fall. With short-term rates on the way up, other interest rates won’t stay low forever, either. But across all bond sectors, from high grade to high yield, rising rates can have positive effects. We believe investors should see a rise in rates as, ultimately, a good thing for bond portfolios. (And by ultimately, we mean just a few years.)"
"What’s the source of this higher growth? First, as you reinvest the coupon income that your portfolio pays, you’ll be able to reinvest it at higher yields. Income matters: for investors who use bonds to generate income, rising rates change from a threat to an opportunity. Second, as the bonds in your portfolio mature, their price pulls back to par, and you can reinvest their principal value in newer, higher-yielding bonds."
2) Rate Expectations by Buttonwood via The Economist
"This is a crucial question. The Federal Reserve’s benchmark rate averaged 2.96% in the first decade of the 21st century but 5.15% in the 1990s. Imagine the effect on the borrowing costs of mortgage-holders or small businesses if rates moved back to the latter level.
Before homeowners and small business breathe too big a sigh of relief, remember that this discussion has concerned the neutral level of rates. Rates could go higher if central banks decide they need to rein back the economy, perhaps because inflation returns. Richard Barwell of Royal Bank of Scotland says there may be too great a belief in 'the miracle of immaculate monetary exit'. This would require monetary stimulus to be withdrawn before the economy recovers, not after, and for central banks’ economic forecasts to be unerringly accurate.
Since central banks failed to anticipate the debt crisis of 2007-08, this is an attitude of the purest optimism. Given the debt burden still facing the rich world, the risks of policy failure are enormous."
3) Yields Likely To Keep Falling by Erik Swarts via Market Anthropology
"Despite the strong GDP print yesterday that reinvigorated the raise-rates camp and sparked an almost 4 percent rally in 10-year yields, we continue to feel these participants are once again placing the cart before the horse, when it comes to what Chairwoman Yellen has repeatedly articulated will be a "considerable time" after the QE programs are wound down this October – and when they consider their next policy response.
From our perspective, where the rubber meets the road with the specifics of actually raising rates is much further off in the future and only after the markets normalize to this rather significant shift in support – from both a structural and psychological point-of-view. (For more of our thoughts on the effects of this normalization and why we don't find parallels with recent history, see Here)
With respect to 10-year yields, the frictions from the end of QE should continue to support the Treasury market and we expect the next step lower in yields to be taken as the markets stroll into August."
4) Investors Underestimating The Path Of Policy by Rain Capital Management
"Interest rates may be the single most powerful force in capital markets. They are quite literally the cost of money and determine everything from the value of bonds to the price people are willing to pay for equities. We don’t think for a second that the process of rate normalization will be as uneventful as the market seems to be pricing in. No bell will ring or date certain set for unwinding what is now an extremely outdated policy stance. The idea that investors can simply get out of the way when the time comes is unlikely when considering how flatfooted they have been in the midst of interest rate volatility in 2013, rate hikes in 2004, 1994, and so on.
Investors aren’t getting paid much to take risk, so they’re taking more risk in an attempt to make up for it. We’d much rather use this opportunity as a pit stop; a time to fortify portfolios during which the cost of not being fully exposed is minimal but the cost of making a mistake could be large. To paraphrase Warren Buffet, reducing risk may be uncomfortable, but not as uncomfortable as doing something stupid."
5) Fed Creating Bubbles By Inflating Equity Risk Premium byAswath Damodaran via Musings On The Markets
"If you accept the notion that the Fed controls interest rates (that many investors believe and Fed policy makers promote) or even my lesser argument that the Fed has used its powers to keep rates below where they should be for the last few years, the consequences for valuation are immediate. Those lower rates will push up the valuations of all assets, but the lower rates will have a higher value impact on cash flows way into the future than they do on near-term cash flows, making the over valuation larger at higher growth companies.
Consequently, a reasonable argument can be made that the Fed has been an active participant in, and perhaps even the generator of, any bubbles, real or perceived, in the market. In my post on market bubbles, I did agree with Ms. Yellen on her overall market judgment (that traditional metrics are sending mixed messages on overall market valuation) and used the ERP for the market, as she did, to back my point. In particular, I noted that the implied equity risk premium for the market at about 5% was high by historical standards (rather than low, which would be a indicator of overvalued stocks). However, breaking the ERP down into an expected stock market return and a risk free rate does point to an overall disquieting trend:"
"Note that all of the expansion in ERP in the last five years has come from the risk free rate coming down and not the return on stocks going up. In fact, the expected return on stocks of 8% at the end of 2013 is a little lower than it was pre-crash in 2007 and if the risk free rate reverts to pre-2008 levels (say 4%), the ERP would be in the danger zone. Put differently, if there is a market bubble, this one is not because stock market investors are behaving with abandon but because the Fed has kept rates too low and the over valuation will be greatest in those sectors with the highest growth."
The last article is most interesting as two of the primary "bullish arguments" has been the spread between earnings yield (the inverse of the P/E ratio) and the interest yield on bonds, and the non-inversion of the yield curve. I have argued in the past that the so-called "Fed Model" is flawed for many reasons. However, an increase in interest rates will very quickly nullify both of those bullish arguments because the denominator in both cases can rise MUCH faster than the numerator.
via Zero Hedge http://ift.tt/Xq0uTc Tyler Durden