Interest Rate Spike, How Bad Will It Be?
Without a doubt, one of the most pressing questions that should be on all investors’ minds right now is how high will interest rates go. But perhaps even more importantly, the proper conclusion must be reached as to what effects it will have on the market and the economy once that interest rate level is reached.
Many Wall Street pundits have overlooked the fact that these artificially-low interest rates weren’t going to be around for very long. And, out of the few that concluded rates would soon rise, most still fail to recognize the pernicious fallout that lies ahead.
To best answer the question as to where U.S. Treasury yields are headed in the next quarter or two, it is important to know where they would be without the manipulation of our central bank and, also, absent the threat from an imminent collapse of a major foreign currency. The current yield on the Ten-Year Note is 2.5%, up from 1.6% less than two months ago. True, that rate has surged of late but it is still far below its 40-year average of around 7%. Just prior to the beginning of the Great Recession (in fall of 2007) the yield on the Ten-Year Note was 4%–150 points higher than today. Looking at rates before the credit collapse and European debt crisis gives a good clue as to where rates would be now absent any such yield-suppressing factors.
Also, in the spring of 2010, just prior to the Greek bailout and after two year’s worth of Fed intervention, the Ten-Year still posted a yield of 3.8%. Therefore, it isn’t at all a stretch to anticipate yields going back toward 4% in the very near future if indeed the Fed will soon start to winding down QE as indicated and there is no mass piling into Treasuries from a collapsing foreign currency.
What’s more, the Fed now holds over $3.5 trillion worth of securities on its balance sheet, $1.9 trillion of which are U.S. Treasuries. That compares with just $800 billion at the start of 2008. This means if the market now believes the Fed has started down the path of eventually unwinding its balance sheet the selling pressure will be immensely magnified as compared to several years ago. In addition, due to banking distress in China and a back up in yields in Japan, these sovereign governments may not be able to support Treasury prices to the same extent as they did in the past. These two nations already own $2.3 trillion of the current outstanding $11.9 trillion worth of Treasury debt.
Meanwhile, the Fed persists in sophomoric fashion to scold the market for misinterpreting its mixed messages about tapering the amount of asset purchases. But the big surprise for Mr. Bernanke and co. will be the realization that they have much less control of long term rates than they now believe.
Once the market perceives the exit for QE is near, yields will rise. Nevertheless, expect most on Wall Street to claim the increase in rates has its basis in a growing economy and, therefore, represents good news for markets. But the true fallout from interest rate normalization will not be pretty; for it will reveal a banking system and an economy that is perilously close to insolvency.