Rates Rise, Prices Fall

Interest rates are moving higher. While markets do not move in a straight line, they do move consistent with the trend. The trend for interest rates is up and the ramifications for investors worldwide will probably be huge.

I like to watch bellwethers and my current favorite is the longest US Treasury thirty year bond. This bond peaked in price in February with an all-time low yield of 2.22% and by June the yield had jumped one full percentage point to 3.22%. Since then the move has consolidated back below 3% but perhaps by the time this is published the yield will perhaps be headed higher again.

Why should we be concerned about a thirty year bond almost nobody owns? Well, actually we all probably have a stake in the bond because the Federal Reserve owns a tremendous amount of all long-term (ten years and longer) treasury bonds. The Fed chose long-term treasuries as its vehicle of choice in executing its Quantitative Easing plans over the past several years.

You remember QE? The Fed kept doing it again and again in an attempt to keep yields low and therefore asset prices high. So why the reversal in bond prices this year? Good question, but an irrelevant one. The important part is that interest rates are rising.

The Fed is poised to raise short-term interest rates later this year and it claims that it will depend on the data as to when it begins the “liftoff” of rates. The data I’d be looking at is the yield on the bellwether US Treasury bond. When the interest rate on the bellwether rises above 3.25% we should probably see the Fed follow with liftoff.

What about growth? What about inflation? There isn’t any growth or inflation worth talking about (and there hasn’t been for several years). Interest rates are rising and it doesn’t (appear to) have anything to do with inflation.

The inflation story is a dead one in my opinion. Inflation is yesterday’s news. For most (if not all) of our investing life, lower inflation and lower interest rates worked a powerful narrative together. As inflation declined from the early 1980s, so did interest rates and the value of financial assets boomed. Thirty years of narrative bliss with a few financial crises thrown in.

Now that a new trend is in place with higher interest rates, the sooner you ditch the inflation narrative, the better for our understanding if what is now at work. Interest rates are rising and everyone who believes inflation will soon follow (or is the cause, whatever you prefer) may be disappointed.

The Fed has fed us the line that growth and demand (and inflation) are just around the corner for years now. While the Fed and its cadre of Fed watchers patiently wait, I have watched the bond market. Instead of growth, demand and inflation we have seen the end of a long-term trend and the creation of a new trend with respect to interest rates.

Under a rising interest rate trend I believe the market will expose weaker credits and we will see greater volatility along with lower asset prices. Think about that for a moment. A lower interest rate trend moved financial asset prices higher for decades. A rising interest rate trend will lower asset prices. This is not anyone’s plan, it is simply the result of a long, long trend coming to an end.

This is already happening. Look at the energy sector. One short year ago the industry was riding high and oil prices were over $100/barrel. Loans, debt, equity and bonds were being created by the billions and “high yield” investors could not seem to get enough of the paper.

Then poof, it was over. Yields are up dramatically and asset prices have plunged. For someone only looking at the interest rates on bonds in the energy sector, we could easily say the trend has changed. Interest rates were no longer moving lower; interest rates instead surged higher. Volatility entered the picture (nervousness replaced calm) and lending has shrunk dramatically. The “whys” are not important; interest rates rose leaving turmoil in its path.

For participants in the energy sector, Cash has gone from trash to King, seemingly overnight. Last year if you had Cash you were a loser because you were not “putting it to work” in the profitable energy sector. Cash is no longer trash. Today, leveraged participants in the energy sector are lucky to meet payroll (they have cut back drilling activities and other capital spending dramatically already) and the idea of borrowing more money is but a fantasy. Perhaps, like the Fed’s outlook these past years, things will be better next quarter.

Instead of growing and borrowing and increasing wealth in the world, the energy sector appears to be doing the reverse and this is when things get interesting. Lenders want to be repaid. Lines of credit fail to get renewed or they are sharply reduced. Cash continues to be in short supply; the cost of Cash (interest rates) is thus higher. Bottom-line, asset prices fall. Falling asset prices are not where you want to have your money.

Rising rates beget falling asset prices. Yet while interest rates have always appeared to be volatile, the trend was always down, thus moving asset prices ever higher. Until recently. We have also had other areas of our economy booming when others had faltered. Until recently. We have always had emerging markets emerging, especially China. Until recently.

My job is to continue to find you assets that continue to make sense regardless of the new trend in interest rates. My job is to continue to keep your liquid assets liquid as Cash becomes more valuable in an environment of rising interest rates and falling asset prices. This is nothing new, it is what I have worked to deliver you these past number of years as the trend change occurred. In your bond investing I believe we have been ahead of the curve. Do not let the trend change sink you with respect to your other assets.