June 21, 2013

30 Years of Higher Rates?

June 21, 2013

30 Years of Higher Rates?

Rates rose dramatically this week. Concern that QE was not going to last until hell froze over caused something close to panic selling of everything this week. QE has not benefitted the economy to any significant extent. The first 2 QE’s triggered increases in commodity prices. The current one created increases in equity prices. The idea that QE would end caused significant losses in equities this week.

As of June 12, 2013 the Fed’s H.3 report showed $1,963,277,000.000 ($1.96 trillion) in excess banking reserves. That is $505 billion more that excess reserves were at the end of 2012. Essentially, that $85 billion/month in QE has wound up exactly where it started – at the Fed. It is now in the hands of bankers waiting to deploy it. The important word is “waiting.” The Fed has put half a trillion dollars into the banking system but what is now necessary to generate economic growth is to get that money working in the form of loans. Other regulations (Dodd-Frank and Basel III) are discouraging lending.

30 Years of Higher Interest rates?
The dramatic increase in rates this week could be partially undone in a couple of weeks, but it’s the much longer term that I want to look at today.

If you look back at the history of interest rates, you will see a long-term 60-year pattern. Roughly speaking, interest rates move up for 30 years and then down for 30 years.

Interest rates moved down from 1920-1949 – 29 years. They moved generally up from 1949-1979.

In 1983 Volker started a new way of using money supply as the main tool for controlling the economy, and 29 years later in 2012 home loan rates fell to new lows.

It looks as if interest rates will move up for the next 30 years. Do not despair. They are not going to go constantly higher. There will still be up and down cycles within this trend.

The following is a chart of the history of corporate bond yields going back to Colonial days. I am using corporate bonds because they have a longer history than Treasury debt. In this long term up-cycle we will still have peaks and troughs but the line connecting the successive peaks or troughs will be sloping upward for the next 30 years.

For many years I have been talking about the cycles in the 30-year Treasury bond yields. I have always talked about 3 cycles: the daily which lasts 15-20 days, the weekly which lasts 8-12 weeks, and the monthly which lasts 12-15 months. For clarity, when I says 15-20 days I mean 15-20 days up, followed by 15-20 days down.

What I am suggesting is that there may be an even longer 60-year cycle (30 years up and 30 years down.) If there is such a cycle and we are at the start of a 30-year increase in rates, let’s first note that this does no go straight up. The daily, weekly and monthly cycles will still be there.

Also take note that the last time there was a 30-year upcycle in interest rates the economy flourished. Wealth increased and both employment and the housing market were strong.

This is an important point–the economy can do well even with high interest rates.

This seems incompatible with the never-ending story we are told, which is that the Fed’s low interest rate policies cause economic growth. We have had negative real (inflation adjusted) interest rates and GDP is barely moving. This week Bernanke said that QE would soon start tapering and market participants sold equities, Treasuries, and gold.

People need to get ready for a lengthy cycle of higher interest rates.

What should you do?

1) avoid adjustable rate home loans if your expected time horizon in the home exceeds the initial ARM term.

2) think twice about making extra payments on your tax deductible 3.625% home loan. You may find those dollars more useful if savings rate were > 4% or if assets were appreciating.

The question you might ask is this: what is it that will drive the 30 year up-cycle of rates?

My answer is simple. There is one large driving force: fiscal unsustainability which has created enormous national debt, both the formal national debt and the $70 trillion present value of the underfunding of entitlements. Bad fiscal policy is being addressed in Europe and is not yet being discussed in the U.S. I found most telling this one phrase from the FOMC statement on Wednesday: “…but fiscal policy is restraining economic growth.” I guess I am the only person who noticed.

Higher Treasury rates mean that it will cost more to service the national debt. This is unfortunately a necessary step in inducing Washington onto a path of fiscal sustainability. Servicing the debt has not been painful enough to make anyone in Washington care.

How high will rates go? No one knows. But these notes are a few things to monitor along the way.
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