The Interest Rate Roller Coaster

150305_INV_KEEPCALMFor almost forty years, the interest rate roller coaster has been going downhill. But digging underground tunnels, metaphorically speaking, or charging depositors, instead of paying them to hold their money can only last so long. So for the last few years, the roller coaster ride has been up and down, and now up again.

After their recent policy meeting, the Federal Reserve announced that they would raise their federal-funds rate by a quarter percentage point to between 0.50% and 0.75%. And a lot of people I talk with think this announcement marked the beginning of the most recent climb upward for the roller coaster. But upon closer examination, it becomes clear that rates (as measured by Ten Year Treasury yields), began rising in July.

The Ten Year Treasury bond has been around since the late 1700’s. Here’s an interesting chart on that. The yield on this historic implement of our nation’s financial structure hit its lowest point ever this past July at 1.37%. Prior to that, the lowest point was 1.46% in 2013. In between, the yield doubled to just over 3% on fears over the impact of the end of quantitative easing from the Fed (the taper tantrum). It seems maybe we’ve been rolling up and down at the bottom for a few years but it also seems to follow that we might be headed upward on a big climb right about now. You can almost hear the clicks of the roll-back chain.

The financial media talking heads seem to think we’ve seen the bottom and proposals to spend a trillion dollars on infrastructure and cut taxes will create more inflationary pressure.

My opinion? I think we’ve had plenty of inflation all this time. Remember, inflation is not rising prices. Rising prices are a symptom of inflation. At its core, inflation is the decreasing value of our currency. And the glut of supply central banks have created has caused inflation, evidenced by higher than ever stock and bond prices, real estate values to a slightly lesser or more isolated degree, and consumption items the owners of these assets want or need, like the most expensive schools, and the best health care. I think the Fed is raising rates under the cover of bond market speculation of increased inflationary pressure to give themselves some leverage for the next crisis. Because they have very little of it after almost seven years of unprecedented stimulus.

But I don’t claim to know if the low point we saw this past summer was really the bottom. When the bubble bursts again, odds are good the herd will plow back into US Government Bonds in search of safety, which could drive yields back down again. That reminds me. It’s also critically important for investors to understand that the bond market herd controls the interest rate markets, not the Fed. Obviously, the Fed has significant influence, but the herd is bigger than the Fed. If the herd is spooked, the Fed will get trampled.

It’s also interesting to note that the stock market is still rising (at least certain sectors are), even though rates are rising. Much has been said about the post crisis bull market in stock prices being built on low interest rates and stimulus from the Fed. Just how far the bull market in stocks can run when the bull market in bonds appears to be fading remains to be seen.

While I rant about the Fed and the big banks all the time here, this is, after all, a personal finance blog. So iif I were to tie this all back to some personal finance insight, it would be this: with rates rising, but still very near two hundred plus year lows, I want to be a long-term borrower, not a long-term lender.

I think history will be very cruel to long term lenders of this period.

For years, savers have been dying for higher interest rates as their deposits lose value. But the lending institutions will postpone increasing deposit rates until it’s explicitly clear the roller coaster is on a sustained upward climb. And all the cash the Fed gave the banks in exchange for their bad debt during the last crisis will make it easier for them to delay even a little longer. This will increase temptation to buy long term CDs and other similar instruments to gain a still anemic, but slightly higher, yield. If the roller coaster is in fact on a long term up climb, this will have been a bad decision, because it amounts to being a long-term lender, to the bank.

Some borrowers have taken advantage of the low rate environment we’ve had and loaded up on long term debt, but some folks I talk to are reluctant borrowers. They follow the emotional pull to try and eliminate debt, which isn’t all bad, of course. Debt used to fuel over consumption is unhealthy, and often disastrous. But debt used in a thoughtful and comprehensive long term saving and investment strategy is a very powerful tool. I see lots of people making extra mortgage payments and refinancing from thirty year to fifteen year mortgages. Even when they don’t have adequate cash reserves, or have all or most of, whatever personal wealth they’ve managed to build in a qualified plan. With rates as low as they still are, I want to lock in for as long a term as I possibly can so I can direct surplus cash flow to capital assets that will offer some potential for mitigating further inflation risk, or to build (short term), cash to mitigate the risk of a deflationary trend caused by bubbles bursting.

Time will tell if we’ve just witnessed the end of the longest and greatest bull market in bonds the world has ever seen, or if this is just another small hill on the roller coaster ride before another dip. What we do know is rates are still very, very low, and hedging one’s long term bets would be wise. Because sooner or later, the ride comes to an end, and if you aren’t properly buckled, you’ll be one of the many that gets hurt.