A New Presidential Administration Previews End of Low Interest RatesSubmitted by Ashland Heights Investments on December 28th, 2016
Equity investors stand at crossroads--High income investment mix presents compelling solution
By: Eric M. Robken
A new President has taken office. Along with the change in guard, an expectation of sweeping policy changes begins.
Not the least of which is the US Federal Reserve Board’s policy on interest rates. A governmental policy which touches nearly every aspect of our financial lives. Whether it is getting a quote from a mortgage broker, buying a car, signing up for a credit card, or simply holding cash, the interest rate situation affects everyone.
The bottom line is that the Federal Funds rate, which sets the baseline for all credit rates in the U.S., has been at or near zero for the last ten years, and this gave rise to a debt-fueled binge at the federal government level, as well as at municipal and consumer levels.
Debt Bubble Induced by Low Interest Rates
Those accustomed and addicted to effortless debt will be faced with the uncomfortable proposition of going cold turkey when rates return to reasonable levels. Early indications of the aftermath are not pretty-- Several major U.S. cities and territories have defaulted or made major restructurings to entitlement obligations. If this is a sign of things to come, we are in for a terrible awakening. It’s hard to imagine a scenario in which the capital markets react positively to such a contraction of credit, as so much of the economy is driven by a healthy credit market—consumer spending, housing, industrial expansion, export/import trade, banking, to name a few.
Principal Factors contributing to the highest Treasury prices in history
If you compare the 30-yr bond yield chart to the US federal debt since 1980 the two are very negatively correlated, further evidence that lower interest rates have in artificially inflated the federal government’s balance sheet. The problem is that with rates approaching zero and gross public debt over $25 Trillion, the balloon has reached its elastic capacity and it’s time to deflate… or burst. So, the question is not “Will rates go back up”, it is “When will the inflection point occur and what will be the consequences?”
Several major factors indicate that we could be at or near this inflection point.
3 Principal Factors that have contributed to the highest Treasury prices in history
First, let’s look at the factors that have led to this historic bubble in Treasury bond prices (or fall in yield, said differently).
- Persistent Economic Weakness Since The Great Recession
- Strong U.S. Dollar
- Low-cost Imports and Large U.S. Trade Deficits
The zero-rate policy was first instituted as a way of staving off a massive economic contraction during the financial crisis. It appears to have achieved that goal, but 8 years later while interest rates remain near zero, we have a federal budget deficit at all-time highs. In other words, the medicine became the cure.
Economic weakness in other emerging markets around the globe have made the U.S. condition look good by comparison driving up the value of the Dollar to a 13-year high.
Low-cost imports, such as Apple’s products from Southeast Asia for the iPhone and iPad, or steel from Korea, have kept consumer costs down, keeping a ceiling on inflation, which is a key measure in determining the interest rate policy.
3 Factors that are pressuring yields higher/prices lower
There are several factors from many different angles that are putting upward pressure on yields.
- President-elect Trump’s Policies of Cracking Down on Low-cost Imports
- U.S. Economy strengthening
- Interest rates just can’t stay at the bottom forever
The Presidential election gave a quick bump to the 30-year yield as President-elect Trump has taken a clear stance of returning the Federal Funds rate back to reasonable levels.
The U.S. economy, although not strong by most broad measures, has expanded every year since 2010. This should give reassurance to the Reserve Bank that interest rates can be hiked without immediate damage.
Thirdly, the reversion to mean is a strong factor when it comes to financial markets in general, and here is no different. We live in a finite world and in such a world, nothing can go higher and higher infinitely. Especially when the foundation of such an increase is fueled by things that also have a finite life with a defined timetable. The rise in interest rates will cause stress and uncertainty in the financial markets.
Domestic Fixed-Income May Bring Long-Term Stability
There are several high-income asset classes which reflect a safety feature similar to Treasuries while protecting against inflation and interest rate hikes. These classes produce sustained income with modest growth in core value over time, keeping pace with, or even outpacing, the value of inflation caused by the next era of rising rates.
Core portfolio components include real estate investment trusts ("REITs"), midstream oil & gas master-limited partnerships ("MLPs"), and bond funds. Such investments demonstrate capability of upward float with rate hikes while generating steady income, the ideal formula for investors approaching or in retirement, or who desire to have a medium term savings vehicle.
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Eric M. Robken is the founder of Ashland Heights Investments, an advisory and asset management firm in Houston.