interest rate environment

Will Rising Rates Derail the Economy?

© Can Stock Photo / focalpoint

At 228Main.com, we are voracious readers and consumers of information. Nothing happens in a vacuum. We therefore pay attention to the economy, the markets, and our holdings, as well as look for potential opportunities to invest. Recently it was time to sort out what it all might mean.

Rising interest rates, long expected here, have caught our attention. Home mortgage rates are at a seven year high1, and other consumer borrowing rates have increased as well. If we spend more on interest payments, we have less to spend on other goods and services.

We investigated, and learned that total household debt payments actually remain near the lowest point in many decades, although they are rising. But the total debt balances are at record highs, above the level reached before the 2008 credit crisis. What gives?

The answer is in the interest rates. Higher debt levels financed at lower rates have reduced our payments as a percent of income. If loan interest rates continue to rise, however, we will probably see more household income go to payments on debt.

There is another piece of income that doesn’t get spent: our savings rate. When we feel confident about the future and our 401(k)’s and other investments are growing, we tend to save less. When the outlook darkens, we tend to save more.

Our savings rate declined from 6% of disposable income at the end of the last recession to the 3% neighborhood now. Historically, it has been slightly lower at times—but we are probably close to the bottom.

The amount we spend is what is left after debt payments and savings—and one more thing: taxes. Taxes, like the other factors, seem to be at relatively low levels now—not likely to go lower. The 2017 tax reform cut levels sharply.

We believe it is likely that record amounts of debt face rising rates in the years ahead; our savings rate will rise sooner or later; and there is no more room to cut taxes. The net effect of these three things seems likely to eventually reduce consumer spending, which is an important driver of the overall economy.

We do not think we are on the verge of recession. Other indicators point to continued growth. But we are in the middle or later stages of the growth cycle—not the beginning. We are looking at opportunities that fit the times, as always.

Clients, if you would like to discuss this or anything else, please email us or call.

1All data from https://fred.stlouisfed.org/. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. Accessed May 22nd, 2018

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Hidden Risk of Bonds

© Can Stock Photo / alexskopje

If I were to tell you that you could buy a bond that would pay out interest of 5% or more per year for the next 30 years, that might sound like a great deal. It’s certainly a great price in today’s interest rate environment—nearly double what 30-year U.S. Treasury bonds pay—and best of all, it lasts for 30 years. Other income may come and go, leaving you scrambling to find replacement investments that may or may not have the same yield, but this hypothetical bond will (one hopes) be around paying you the same rate for three decades. Sounds like a lead pipe cinch, right?

Wrong.

There is a catch. A 5% yield that will not go down for 30 years sounds great in today’s interest rate environment—but it is also guaranteed not to go up for the next 30 years. If interest rates rise and yields go up, your 5% bond will inevitably be left behind. If you try to hold onto your bond, your returns will look pretty pitiful compared to newer bonds that pay more interest and inflation will eat away at your purchasing power. If you try to sell your bond to hop on board higher yield issues, you’ll have to sell at a deep loss—no one will want to pay full price for your 5% bond if they can go out and buy 8% bonds instead. Either way, the damage would be considerable.

In investment terminology, this feature of bonds is known as interest-rate risk. The longer the bond maturity, the higher the risk (which is why longer term bonds pay higher interest.) Not only is it more likely that interest rates will rise at some point during the holding period, the damage will go on for longer before you get your money back at maturity.

We have many reasons to be nervous about holding on to long term bonds, even ones that have performed exceptionally well. For the past eight years, the Federal Reserve’s near-zero interest rate policy has been distorting the bond market, which is why overall bond performance looks so good in retrospect. But we believe that if it is impossible for something to continue, it won’t. Sooner or later the Fed will have to return to a sane interest rate policy, and when it does, long-term bonds are going to suffer badly.

We’ve been in this low interest bubble for so long we’ve forgotten what a realistic bond market looks like. If you find yourself scratching your head at the idea of selling off bonds that seem like a good bet, realize that what looks like a good deal now may not turn out to be so good in a few years. If you have any questions about your holdings, give us a call or email us to talk.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.