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When rates are rising because of an improving economy at this point in the economic cycle, it is a good thing…..regardless of what you see and hear on TV

“Davidson” submits:

With very few exceptions the media commentary is rife about a pending collapse of the economy, housing market, stocks and bonds due to rising rates. There is even a forecast for the Dow Jones Index to fall to 5,000. I do not think so!!

Let’s take a step back and review what rising rates actually mean at this point in our economy and understand why rising rates are good for our economy, stocks, housing but not for bonds. I am going to refer to the chart below- See chart: T-Bill, 5yr & 10yr Treasury Rates Move Asymmetrically- which compares the constant maturity monthly closing rates of three Treasury securities, T-Bills, 5yr Treasury Bonds & 10yr Treasury Bonds, with the peaks and bottoms of the SP500 ($SPY) for the economic/investment cycles noted. The dates of SP500 peaks are highlighted with RED ARROWS while the dates of the bottoms use GREEN ARROWS.

The key feature one can see in the chart is that rate changes are asymmetrical, i.e. they do not rise and fall across all maturities in lock-step with each other. What should be readily apparent from looking at the rates for the three maturities shown is that at stock market peaks short term and long term rates historically converge to roughly the same rate of return. In December 2005 the rates of these three maturities converged at the ~4.5% level which meant that short term rates and long term rates were essentially identical. This is a condition called a “Flat Yield Curve”. Beginning in July 2006 the T-Bill rate was actually higher than rates for 5yr or 10yr Treasuries which is called an “Inverted Yield Curve”. The same condition also occurred during the SP500 peak in March 2000 when the 5yr and 10yr Treasury rates were nearly identical at ~6%. T-Bill rate rose to be higher than the 5yr and 10yr in August 2000. What should be very clear is that short term and long term rates rise asymmetrically with the 10yr Treasury rate rising first followed by the rise in the 5yr Treasury rate and finally followed by the rise in the T-Bill rate to the point in the cycle when all three rates are fairly close to each other when the equity markets and the economy peak. This is the historical pattern going back many decades.

The condition of a Flat Yield Curve is always associated with less lending by banks and other lending institutions. Lending institution profits come from borrowing at low rates and lending at higher rates. The difference in the rate of borrowing and the rate of lending is called the “Spread” and is the source of bank revenue and profits. If short rates and long rates are similar, lending institutions cannot lend profitably and lending slows appreciably. When lending slows so does business activity, employment and corporate profits. This is what occurs at stock market peaks and why rates peak when the stock markets peak.

The rates of the three maturities are quite different at market bottoms. At stock market bottoms all rates are lower than those at stock market peaks, but there is substantial difference between short term rates and longer term rates. The reason for this is that investors of all types fear investment losses and place large quantities of capital into the safety of short term Treasuries. Short term Treasuries as opposed to longer term Treasuries carry little illiquidity, market or inflation risk. T-Bills are the investment of choice for preservation of capital during times of severe market stress. For this reason T-Bills rates are lowest of the three. Globally, T-Bills and other short term government obligations are havens for capital when investment markets correct. The T-Bill has been universally recognized as the most desired safe haven for capital and it has been the security with the lowest rate of return during the strongest period of market distress.

The condition of the “Yield Curve” in periods of market corrections is closer to what is termed the “Normal Yield Curve” (see chart Yield Curve as at 9th February 2005 for USD from Wikipedia http://en.wikipedia.org/wiki/Yield_curve)

Returning to our chart, T-Bill, 5yr & 10yr Treasury Rates Move Asymmetrically, one can see wider rate differences at SP500 bottoms. This provides the condition for improved bank lending but lending expansion does not occur instantaneously. During market bottoms, lending institutions are struggling to deal with loans issued just a few years before which have now defaulted. With future business prospects viewed through the perspective of the current correction, lending becomes cautious and Treasuries are preferred for bank capital rather than lending into a marketplace with dubious prospects of payback. The lending spreads are positive but narrow and provide little room for underwriting mistakes. But, as recovery begins to take hold, lending begins first to Prime Borrowers, i.e. these are borrowers with liquid capital in excess of the loan amount who are deemed very low risk. Later as the signs begin to filter in that the economy is showing improvement, the banks begin to sell Treasury holdings and replace these with loans to less than Prime but still high quality borrowers. The net effect is to begin to drive longer term Treasury yields higher. The selling of longer term Treasuries depresses the value of investor and business Treasury holdings which results in additional selling to avoid these portfolio losses. Some of these funds are used for higher return investments, i.e. stocks, other bonds and some are redeployed to short term securities, i.e. T-Bills, which keeps T-Bill rates low while longer term 5yr and 10yr rates are rising. Rates move asymmetrically!

Let’s repeat what occurs at market bottoms. Early in the economic recovery, bank lending is tepid, but as the economy accelerates so does the lending. What is seen in the yield curve as the economy improves is the condition more approaching the Normal Yield Curve shown above. Longer term rates rise while short term rates remain low and spreads widen. The wider spreads banks and lending institutions receive on loans improves their profits. With the rise in profitability and perceived economic improvements, lending moves from Prime Borrowers to those with less pristine credit quality. It is because spreads and profits are so improved that lending now expands down the credit quality scale. The lending volume expands because perceived risks are less while spreads improve profits and risks are more easily absorbed or become diminished by the fact that the economy continues to expand. All along the way the longer dated Treasuries are sold to fund higher returns on lending and rates rise asymmetrically improving spreads which accelerates lending. This pattern continues till even the T-Bills begin to be sold. T-Bill rates rise is an additional signal of improving economic activity to many as capital is drawn into areas of higher returns. Rates move asymmetrically!

Because rates move asymmetrically, rising rates at this point in our economic/investment cycle are positive for higher stock prices. The current environment is typical of the historical pattern of economic recovery and the normalizing of the Yield Curve.

My advice is to ignore the calls to panic issued by those who believe that an imminent market decline is close by. The current rate rise is actually a signal of an improving economic environment. Today’s lending means that future quarters are being funded for stronger housing and construction markets, stronger employment trends, stronger retail sales, stronger corporate profits and higher stock prices.

We may see some volatility due to those who do not understand the meaning of higher rates at this point in an economic expansion. We should be prepared to live with it.