This week the Fed raised their overnight lending rate 25 basis points to .75%. But this is old news. The market basically did it for them with the bond market’s overreaction to the election results with president-elect Trump. So what! The Fed raised their rate 25 basis points. The 10 year US treasury yield has already risen from a July 8th low of 1.38% to 2.6% as of today– that’s 122 basis points. As interests rates rise, bond prices decline and the bond market has been selling off since July– two sides of the same coin. So, did the bond market really see a Trump win back in July? The bond market is very conservative, so did they see a republican win? People have been saying the increase in interest rates generally is a reaction to the Trump win, but that’s not so, because the increase started in July. Or is there an underlying trend that the press hasn’t picked up on yet? Political events and politicians really don’t have a large impact longer term on economic trends unless the effect major policy errors or war. The longer term trends typically are due to larger underlying pressures.
Higher rates attract foreign investment which bids up an already strong dollar which is great for imports, terrible for U.S. exports and foreign investments if you have them. Stocks have moved higher but many anticipate the stable dividend stocks with bond-like qualities which have been so strong for so long will also go the way of other income producing assets– aka bonds. Precious metals have fallen as the dollar has increased– that’s a typical inverse relationship. Commodities have fallen too as they are priced in U.S. dollars and have an inverse pricing relationship– except for the price of oil which has rallied approaching $60. Say what? An oil rally? Some have suggested that oil is the reason why bonds have sold off since July, pushing interest rates higher. Trump’s campaign statements about infrastructure spending and lower taxes to generate growth in the economy has further spiked interest rates.
Back to oil for a minute. Why is oil rising? Is it because of increased world demand or even U.S. demand? Has OPEC changed their stance? Has Saudi Arabia? What is the reason for oil prices bidding up? I do know, just like my car’s engine needs oil to run smoothly, the world economy needs oil to operate as well, so is demand coming from somewhere? Or is oil supply the driving factor? Someone knows, I don’t.
These are the current economic conditions. They are also the market’s expectation of rising interest rates. We have all had 10 years to think about these relationships and the implications of increasing interest rates. We knew this would happen, right? So that is why the Fed’s rate increase is old news. Further and more important, Trump’s win is also probably an overreaction even if the price of oil is an overreaction. Nevertheless, some have discussed that a 10 year U.S. Treasury yield of 3% would be enough to slow down the U.S. economy, which is already having its own troubles trying to grow, let alone the world economy. Is 3% possible? Or is the there finally enough strength in the world economy that a rise in U.S. rates wouldn’t be harmful? I don’t know if 3% is the tipping point.
Interest rates are likely going to come back down a bit in the short term, but probably not to the prior July low. I think the bond market has overreacted to recent events. But I think longer term the trend in rates has begun. Having said that, I am not a forecaster of interest rates, nor do I even try. It’s better to follow the market, is my motto. If you can’t beat them, join them. The Fed’s 2017 forecast is for 3 more rate increases.
Anyway, here’s my reasoning for why I think the interest rate trend is moving higher– at a very slow pace. These trends take time to develop. Trump’s policies will have to make their way through Congress and that takes time as we all know. Commodity prices are low and therefore, finished goods prices are not going to be going higher until producers start paying more for raw commodities. A strong dollar helps import prices remain low, so no inflationary pressure there either. Global inflation isn’t a concern currently either. Inflation is typically a treat at the end of a strong period of growth– something we have not had.
U.S. wage growth while ticking up is also not terrible even with a low unemployment rate. But that never seems to stay low for long and with labor market participation rates at historic lows with baby boomers retiring, employers are left with younger new entrants who have less experience and are more willing to work (forced they may say) for a lower wage. So wage pressures will remain subdued for a while as well. So I think we have 1 or 2 years more before we really start to see rates return to more normal, historical levels with U.S. Treasurys eventually settling in the 4 to 6% range. Nevertheless, the chart below helps me, at least, keep a rising rate increase in perspective. Look how long it has taken rates to drop from the earily 1980s highs. I don’t see an overnight return to high interest rates, do you? I’m not worried.
Another trend that is being discussed is this one on unemployment. As mentioned above, unemployment never stays at low for very long. When it is at low under 5%, guess what happens? An economic recession occurs. This pattern has occurred almost every time since the 1950s and probably longer than that. Why we can’t remain at low unemployment for long is a mistery. I don’t think economists have fully figured it out, but you’ll earn a Nobel prize for sure if you did! If you have, please let me know! But then the optimist in me sees the opportunity when unemployment is high on the other side of the recession. High unemployment is a good sign that the economy is starting to recover. See the chart below. And remember, none of this should be considered investment advice. These are just my observations.
Additional sources for analysis.
Here’s the Fed’s public announcement on their rate decision.
The Wall Street Journal had a good article on the news. (WSJ)