It seems that no matter what is happening to the financial markets – one thing investors can always count on is a steady stream of predictions from the experts. No matter that many of these predictions are couched in generalities or are just plain wrong. Along those lines, and asking for some forbearance, here is one more.
So what is this prediction? Interest rates will be going up and maybe generational lows have been seen when it comes to interest rates. It would appear that for next year, investors and borrowers should start to include the scenario of higher interest rates in 2010 and beyond. To be sure, they will not rise in a straight line – nothing ever does.
Looking at the data for 2009 shows that Treasury bonds turned in their worst performance since 1978 – due in part to the flood of borrowing being done by the US government and mounting fears of inflation. Another reason for this poor performance of US Treasury bonds is that investors who were taking refuge in bonds during the financial meltdown are now selling them to reorient their portfolios towards more risky assets. Over the last twelve months, some investors were so panic stricken that they bought short term Treasury instruments (Treasury Bills) even though they were yielding negative interest rates. Put another way, the US government was able to borrow money and the lenders (investors in short term Treasury bonds) were paying for the privilege of making the loan. Panic tends to breed irrationality.
Even if we do not see the dramatic rise in inflation that some are talking about, interest rates need to get to more normalized levels as things return to at least a semblance of normality. There is no financial crisis, markets are working as they should for the most part and risk appetites are on the rise amongst investors.
If next year does not see at least a gentle but steady rise in interest rates, it will be because fear has returned due to an adverse turn in the economy’s attempt to rebound. If this is the case, we would likely see a sharp correction in global stock markets.
There are some that feel that the economy will begin to buckle if the US central bank walks away from its present program of buying US government debt which was aimed at keeping interest rates low as possible to aid the economy. In addition, this allowed the US government to continue to borrow mind boggling amounts of money. One of the core goals of this debt buying program was to allow interest rates to stay lower for longer. However, the Fed has indicated that it will look to start winding down these extraordinary measures next spring.
Rising interest rates in and of themselves are not enough to send stock markets reeling. What investors should look for is the spread between short term and long term interest rates. The relationship between short and long term interest rates is expressed in the yield curve. As the graphic below shows, the yield curve is a linear representation of the difference between interest rates of different time horizons.
Click to see larger image
When the markets are confident in the economy and monetary policy is accommodative to economic growth, short term rates are lower than long term rates and the banking industry is able to make enormous profits by borrowing at lower short term interest rates and lending at higher long term interest rates. The spread between the short and longer term interest rates goes right to their bottom line.
The inverted or flat yield curve comes about when monetary policy is less accommodative. In response, stock markets tend to begin to price in an economic slowdown. This is exactly what happened by early 2007. Under this scenario, short term rates are higher than long term rates and banks are hard pressed to make loans since they cannot profitably borrow short and lend long. As credit becomes tighter, the economy continues to weaken.
One of the most overlooked relationships – yet one of the most important – is the stock market’s relationship to the yield curve. As the graphic shows, as the yield curve becomes inverted the stock market begins to become steadily weaker and tops out. Conversely, at market bottoms, the yield curve is steeper. Thus it can be seen that the stock markets can often take their cue from the yield curve.
At this point, the yield curve is accommodative and banks will start to begin lending again. Once the monetary authorities start to see this process taking shape in sufficient strength, they will start to pick up interest rates – perhaps at a surprising pace. If they are too slow in taking away the proverbial punch bowl, we could see inflation rear its head and low interest rates will be but a pleasant memory.
This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance.Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.
Pacifica Partners Vancouver Capital Management weekly financial post blog: interest rates, AJ Sull, rising interest rates, Pacifica Partners, Bernanke, Federal Reserve, predictions for 2010, Yield Curve
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