Higher Rates May be Here to Stay (for a while)

And it may get worse (or better) depending on your perspective.

Investors are starting to question the assumption that last year’s dramatic rise in interest rates was an anomaly.  Until recently, it seemed most “experts” assumed that higher rates would quickly tip the country into recession, and that the Fed would then be forced to cut rates to re-stimulate the economy. 

We are now starting to see that this view is probably wrong on two fronts. 

First, there is the assumption that the Fed will be forced to reduce rates back toward the ultra low rates of 2 or 3 years ago.  It’s not likely to happen.  Let’s face it – 1% yields on a 10 year treasury bond, and 2.5% on a 30 year mortgage is NOT normal.  The Fed does not really want to go back there.  It really isn’t all that healthy for the economy to have money avaialable free of charge.

Second, the economy seems able to handle current rates without significant slowing.  Without that slowing, inflation will likely still keep on simmering.  The Fed has learned from the 1960s and 1970s that you can’t give up the inflation fight until the job is completely done.  So rates are likely to remain elevated for some time and might even be pushed a little higher to fight against inflation. 

Third, markets are just starting to appreciate the very important and growing role that US government debt and (out of control) spending is likely to have on interest rates.  The government (foolishly) failed to lock in low long term rates when they had the chance.  That means that the US Treasury is going to be refinancing its ever growing debt burden at much higher rates over the next several years.  Add higher interest cost on debt to the recent explosion in spending, and you have deficits (and government borrowing) soaring to unprecedented levels.  

This means that, even if the Fed wants to cut rates to fight a future recession – it may not be able to have the influence over rates that it is accustomed to.  The US governments thirst for money is going to force ever higher rates on the country regardless of what the Fed wants to do.  This rather frightening prospect of such a debt / interest rate snowball has been written about for many years, and always seemed “somewhere off in the future”.  It is not something that we have ever experienced in this country.  Now many of the country’s most successful bond investors are thinking that we may be reaching a tipping point where government borrowing starts to impact rates in a negative way.  It is seen as part of the reason that longer term rates are starting to move higher again (causing renewed pain for bond investors).  This hasn’t been talked about too much yet – but I think it will become a growing part of the national conversation over the next year or two.     

Why does this (higher rates for longer) matter?  

If you are young you may want to rethink the strategy of waiting to buy your home until rates come down.  If they do – then fine, you can always refinance.  But you may be waiting a long time for that 3% mortgage rate. 

If you are an investor, you may want to rethink your asset allocation.  We had given up on cash-like investments such as ultra short term T bills when rates were near 0% – but with very safe investment now yielding over 5%, it makes sense to allocate a chunk of your portfolio to this sector.  Unlike longer term bonds, these ultra short term instruments do not suffer if rates go up.  (although they also do not appreciate if rates come down).  A moderate 60% stock 40% bond portfolio might now be better positioned as 55% stocks, 30% bonds, 15% cash.   I have been adding cash (in the form of very attractive brokered CDs and some ultra short bond ETFs) to portfolios for over a year.  These positions have outperformed traditional bond funds this year.  

Remember though, that if we do have a recession and rates fall in the future, bond funds will generate capital gains to offset expected losses in stock investments.  They will also continue generating income based on higher yields, since they have locked in today’s interest rates for a longer period of time.   In contrast, very short term instruments such as Money market funds, TBills, and short term CDs will not appreciate in a falling rate environment, and income distributions will quickly reset very quickly to the new lower rates.  This is why these “cash like” investments are not as good at offsetting stock market risk as traditional bond funds. 

Lastly, don’t get starry eyed over potential stock returns.  If rates do remain high, or move higher still, stock prices may have trouble appreciating.    Remember that investors are always offered a choice – safe money at a lower rate, or risky money at a higher rate of return.  If the US government promises to pay higher and higher rates on its guaranteed debt – then fewer people will want to own stocks unless prices get a lot cheaper.  When fewer people want to own stocks, it is harder for stock prices to appreciate.  It is still good to own stocks for the long term, but don’t plan your future assuming 10% per year annual returns on stocks.