Fed chair Yellen raised the Fed’s rate today, as expected, by 0.25%. The Russell 2000 went down 1.25%. The yield on the ten year Treasury went up 0.05%. As short term rates rise this discourages inflation which makes long term bonds more attractive. Currently the dollar based bonds yield much more than bonds of other Developed countries such as Germany or Japan where long term rates are close to zero. The Fed will gradually raise rates in quarter point increments in 2017 by a cumulative 0.75% until the Fed funds rate is in a range of about 1.25% to 1.45%. It is possible that the yield curve could go flat and that long term Treasuries could actually drop to come close to short term rates if the economy teeters in the edge of recession. Thus a 2.0% ten year Treasury rate could happen in a year even if short term rates were 1.4%.
Rising rates will hurt stocks and slow down the economy, ironically making long term bonds more attractive. The Fed’s act signals a commitment to get away from the very wrong idea of zero rate policies and Quantitative Easing, and is also a recognition by the Fed that free markets work best and know best so it is best for the Fed to step back and stop manipulating the markets and let the markets determine what is the appropriate “natural neutral real” level of interest (this where an interest rate is neither stimulating nor anti-stimulating). Thus the rate rise should be welcomed by investors who like bonds and by those who like free enterprise and of course welcomed by yield starved retirees.
The current global economic setup is one where EM countries have borrowed less responsibly than Developed countries and have borrowed in dollars and have gambled on a steady continuation of exporting to the U.S. which will now be ending. The global economy has gotten most of its growth from EM countries, particularly China and its neighbors. This will now reverse, slowing down global growth. The steep rise in U.S. rates will make the dollar go way up above its current DXY index value of 102. It was at 72 during the 2009 crash. The all-time high was 160 in the 1980’s when our rates were much higher than elsewhere. Imagine a foreign borrower having to pay 60% more because the dollar went up that much – who could survive that?
As the EM debtors come under higher degrees of financial pressure due to the rising value of the dollar and rising interest rates they may default on their international debts just like in the early 1980’s and the early 1990’s, leading to a U.S. banking crisis. Basically the global engine of growth (EM countries with lots of debt) are like a “too big to fail” bank which is dependent (as Lehman was) on cheap and stable financing to finance a disproportionately shaky series of ventures. The Developed world and its banks can’t afford for EM debtors to fail, both because it would hurt banks, and it would hurt global growth. Thus the Fed is trapped because if they raise rates they create a global deflationary crisis, far worse than the hypothetical Taper Tantrum of June, 2013, so to avoid the crisis they need to maintain the status quo. Now that the dollar is moving to go up far too high this will make it even harder to stop imports into the U.S. since imports will be cheaper because of devaluation by other countries.
The mistake the capital markets and bank lenders have made in recent decades is that they assumed EM borrowers were as good as Developed country borrowers (similar to the mistake made in increasing loans to Greece when they joined the EU). The problem is that in EM countries loans are often granted to borrowers because of lobbying by crony capitalists saying it is in the national interest to loan money to a major exporter. The accounting systems and bank regulators of the Developed world are quite different from the EM world. It was a mistake for so much debt to be created for EM borrowers and a further mistake was made by denominating it in dollars, making repayment harder during times of crisis. Additionally the simplifier nature of businesses in EM countries renders them less capable of having a corporate moat to fend off competition and thus makes them more vulnerable during a downturn.
The nature of a high achiever individual borrower in the U.S. versus a lower-middle class borrower is that a high achiever may have deep pockets of both assets and career skills, while the lesser skilled borrower may be maxed out in terms of his total resources. If something goes wrong for the moderate income borrower he is much more likely to fail. It could be said that the Sharpe ratio for a loan is higher for borrowers with deeper pockets since they have more emergency resources to stave off failure. By analogy the same concept applies to loans to countries or regions where EM countries have less resources than Developed countries even though on paper their loan qualifications may be similar.
The fact is that risk-on assets like stocks are critically overpriced with a PE10 of 27.5 the stock market is exceeded in PE ratio only by the absurd bubble of 1999-2000. When rising rates trigger this stock crash (by first damaging U.S. banks) then investors will rush for the narrow exit through the fire escape and go into investment grade bonds. Investors should avoid risk-on assets such as stocks and real estate, rather than avoid investment grade bonds. Investors need independent financial advice about the risk of a stock crash. To be prudent one should avoid a high duration in bonds, which means sticking to a duration of 3 or 4 for the portfolio.