How much of a threat are rising interest rates?
Interest rates are on the rise. At some point they will begin to impact the stock market, but is it too soon to worry? Let’s go through the numbers and make some educated guesses. We’ll start with the primary interest rate lever used by the Fed – Fed Funds.
There are three charts representing three time frames for the Fed Funds rate. Long, intermediate, and short-term. Looking at all three provides some perspective.
The Big Picture – Fed Funds
When we look at the very long-term view of the changes in the Fed Funds rate, we see that the recent moves by the Fed have hardly moved the needle. Score a point for the “What, me worry?” camp.
The Intermediate Picture – Fed Funds
When we narrow the time frame, we see a different picture. The Fed took the rate down to near-zero, and kept it there, until just recently. It looks to me like the Fed has more work to do to “normalize” the Fed Funds rate.
The Short-term Picture – Fed Funds
The short-term view is markedly more alarming than the other two views. If the only chart I showed was this one, you might be inclined to think that interest rates were going up so fast that it might be time to bail out of stocks. But that wouldn’t be the right interpretation of this chart. It’s only when you put this chart into context with the other two charts, that you can see where the Fed is in relation to the long-term, or Big Picture.
10-year Treasury Bond
Moving on to the bellwether used by most financial institutions and market pundits, the rate on the 10-year Treasury Bond is also on the rise, although not as sharply as the Fed Funds rate. At the current reading of 3%, the Ten is still well below its long-term average. Score another point for the what-me-worry camp.
If this rate should rise to 4% or higher, the impact would be felt in the stock market and the economy in general. It would put the squeeze on borrowers, the largest being the U.S. Treasury. It would also help the banks by giving them a green light to raise their lending rates, thereby widening their profit margins.
Junk-Treasury Spread
We can’t have a serious discussion about rates unless we include certain rate spreads. This next chart shows the track of the spread between junk bonds and Treasury bonds. This spread helps investors measure the level of worry among bond buyers. A low spread like we have today is an indication that, at least so far, bond buyers are optimistic about the economy and the health of corporate profits.
Treasury Yield Curve – 10-Year Treasury Bond Minus Fed Funds Rate
Lastly, we come to the Treasury yield curve. This is a favorite of economists, Fed members, pundits, and even equity investors. As you can see on the chart, the spread is still positive, but struggling just a bit to stay positive. In other words, the curve is flattening.
When the curve turns negative, it will be a warning that a recession is not far away. For now, the what-me-worry camp is calm and positive. When the curve inverts, they will do what any reasonable investor should do – head for the hills.
Takeaways
If you’ve gotten to the end of this article, it probably means that you are experienced enough to draw your own conclusions about rates. For me, the move higher is cause for increased vigilance, but nothing more. However, now would be a great time to dust off your Plan B – you know, the one you prepared just in case of a market crash? You have one, right?
If you don’t, you need to get one. It doesn’t have to be fancy, or complicated, or cover every contingency. It just has to have an outline of the steps you plan to take in order to protect your invested capital. I do lots of work on Plan B’s with clients, and if you would like to find out more about it, send me a message at info@zeninvestor.org