June 10th, 2015
Written by Elliott Morss, Morss Global Finance
Back in 2013, I explored what would happen when the Fed ended quantitative easing and allowed interest rates to rise. It is now two years later, and they have not risen yet. And further, the IMF is urging the US to hold off increasing rates until 2016.
All that said, it is nevertheless true that the disappointingly slow but steady US recovery suggests the Fed will start increasing rates in the next 12 months. Below, I review and update what I said back in 2013 and offer my latest thoughts on the investment implications of higher rates.
An important question I have: will just stopping the Fed's purchases of Treasuries be enough to cause interest rates to rise? Quite amazingly, with average Treasury rates still around 2%, there is a healthy demand for them. And it is not as if the Treasury has reduced its offerings of Treasuries on the open market. According to the Fed's flow of funds data, the Treasuries "supply" has increased from $5 trillion in 2007 to $13 trillion today. Admittedly, the Fed bought $2 trillion of them as part of its "quantitative easing" program. But that still means there was a global market for an additional $6 trillion of them at 2% rates. Will the Fed have to sell at least part of its store of Treasuries to get rates to increase? Probably.
Looking Forward by Looking Backward
Before getting to investment implications, let's take a look at the impact of lower rates. Back in 2013, The McKinsey Global Institute completed a thorough study on the effects of lower rates on different economic "sectors" in the UK, the US, and the Euro Region. The findings are summarized in Table 1. Overall, and not surprisingly, borrowers benefited while lenders were hurt.
Table 1. – Interest Rate Effects – Cumulative, 2007-2012
Source: McKinsey Global Institute
The savings on debt interest for central governments has been substantial. McKinsey estimates that in the US interest payments on debt fell from 4.8% in 2007 to 2.4% in 2012; for the UK and the Euro Region, the reductions were 5.1% to 3.2% and 4.5% to 3.3%, respectively. Of course, non-financial corporations also benefited from lower interest rates.
Banks are both lenders and borrowers. In the US, banks were able to take advantage of low interest rates to attract funds while keeping their lending margins nearly the same. Not so for UK or Euro banks where lower rates have reduced their profits.
Insurance companies and pension funds are in a tricky position. On the one hand, their balance sheets look better because the value of their bond and other debt holdings have increased. However, many of these institutions issued annuities before rates went down with high guaranteed returns they now cannot cover with their investments. Adjustments will be needed.
Household have also been hurt by the loss of interest income, but losses depended on whether you are net lenders or borrowers. Younger people are mostly borrowers while older people are mostly lenders. McKinsey estimated the differences by age bracket (Table 2). People under 35 saved $1,500 over what they would have paid without lower rates; people 55 and older lost income because of lower fixed income returns.
Table 2. - Impact of Lower Rates on US Households by Age Bracket
Source: McKinsey Global Institute
So looking forward, it is pretty likely that higher rates would reverse these effects: borrowing costs for all would rise and older people would earn more income from low risk government securities.
The main reason for lowering rates was to increase aggregate demand and help countries get out of the 2008-10 depression. Ironically, it is not clear lower rates did much to stimulate demand. In the depths of the depression, neither individuals nor companies wanted to spend more whatever the rate. In addition, even if people wanted to take advantage of lower rates and borrow more, banks had tightened up their borrowing terms.
Let's start with the theory on what should happen and then look at the numbers. In theory, a fall in US rates should result in investors switching out of debt to equity. And now, an increase in US interest rates should increase the global demand for US debt. The theory goes that to finance these purchases, people would sell equities causing stock markets to fall. And in addition, the dollar would strengthen as the demand for dollars to buy US debt increased. So higher rates should mean moves out of equities into debt and a stronger dollar. But for rates to increase, prices on outstanding debt will have to fall. And then there is presumed economic impact of higher rates on economic activity - it should put a damper on economic growth. And this last concern, often reflected in the media, is that higher US interest rates will weaken the already slow US recovery.
So that's the theory. What are the facts? John Reese runs Validea and is one of my favorite writers on investments. In his latest newsletter, he looked at findings from the extensive research on linkages between changing interest rates and stock market performance. His conclusion:
"So, what did I find? Well, I can tell you with certainty that if rates start rising, stocks will go down. That is, unless they go up."
So with nothing definitive there, I decided to take a somewhat different approach. The Flow of Funds data from the Federal Reserve allows one to look at investment holdings of the major investors through time. So in what follows, I look at how their holdings have changed between three dates: 2007 to 2010, 2010 to 2014 and 2007 to 2014. Table 3 provides data on household assets provided by the flow of funds database. Note that households make final investments decisions on only equities, debt, and deposits. Final investments decisions on pensions, mutual funds, and life insurance are made by those entities.
Table 3. - US Household Assets (bil. US$)
Source: Federal Reserve Flow of Funds
So in what follows, I look at the direct investment decisions made by households, pensions, mutual funds, exchange-traded funds and the "rest of the world" between equities and debt for the years 2007, 2010, and 2014.
The data appear in Table 4. They allow us to see what investors did going from boom (2007) to bust (2010) - high interest rates to low ones - and back up out of the depression (2010 - 2014) with rates still low. The reduction in equity in the boom to bust period was not surprising. It probably had little to do with interest rates. Rather, in times of panic, investors want their assets to be as liquid as possible.
Table 4. - Equity Holdings of Leading Investors (bil.US$)
Source: Federal Reserve Flow of Funds
One might think the growth in equity purchases in the recovery period (2010 - 2014) could at least be in part attributable to a switch from debt to equities because of low debt returns. But before drawing that conclusion, it is worth looking at what happened to debt holdings (Table 5).
Table 5. - Debt Holdings of Leading Investors (bil.US$)
Source: Federal Reserve Flow of Funds
It turns out that debt holdings grew rapidly in the 2007 - 2010 period - 10.2% compounded. And rather than there being a sell-off in the 2010 - 2014 period because of lower returns, debt continued to grow at a very healthy rate - 8.0%. Treasuries constituted 55% of the debt recorded in Fed. data in 2007. With a compounded annual growth in Treasuries of 14.3% 2007 - 2014, the Treasury share of debt its share grew to 77% in 2014. This was a huge supply increase, but the market absorbed it without causing interest rates to rise.
Economic Impacts of Higher US Interest Rates
A significant purchase of any form of fixed income security will increase its price and lower its return. And in that regard, the Fed's QE has been quite successful. Interest rates on Treasuries have been kept low. The economic question is now whether these lower rates are increasing consumer and business expenditures resulting in job creation. This is not clear: Keynesians talk of "liquidity traps" where downward adjustments of interest rates have no effect on expenditures and hence no new jobs. One unintended consequence of the Fed's QE program is that people living on fixed incomes are having trouble getting by because Treasury rates are so low.
There is another dimension of the Fed's QE program that is often missed: its effects on international capital flows. When US rates fall, capital flows out of the US. This puts downward pressure on the dollar making US goods more competitive on international markets. Many countries do not like this because it makes their goods more expensive and they try to neutralize it by buying US dollars. By the same token, when QE ends and US rates increase, capital flows back into the US and the dollar strengthens.
US zero interest rates meant retirees and other fixed income earners exited for higher yield. This happened both for US citizens and foreigners. As US bond rates increase, a huge capital inflow back into US government securities can be expected. Dollars are needed for these purchases, so the US $ can be expected to increase in value.
Theory would suggest that as debt rates fall, households would switch from interest bearing deposits and debt to equities. In Table 5, this is examined for US households. Keeping in mind that 2007 were "boom" times, 2010 was the depth of the depression and today the US recovery is well underway but interest rates are extremely low. And data bears out the theory. Both corporate equity holdings and non-money market investments have increased while government and private debt holdings have fallen.
Table 5. - US Household Balances (in bil. US$)
Reese has published an excellent report on the subject in which they attempted to quantify many of the effects. This article summarizes the McKinsey findings and goes on to spell out the investment implications.
b. Higher interest rates will mean higher borrowing costs. While this is true, it should also be kept in mind that people and firms have not been borrowing much even with low rates. This is in part because banks have tightened their lending standards. Consequently, it is not likely that higher borrowing costs will have much of an impact on borrowing.
c. As interest rates rise, debt prices and the prices of other high yield prices will fall. Higher Treasury rates will draw a lot of investments away from "high yield" investments that have been serving as Treasury substitutes. Take a look at Table 5. To substitute for Treasuries, some have purchased: Vanguard Total Bond Market (BND), iShares JPMorgan USD Emerg Markets Bond (EMB), iShares U.S. Real Estate ETF (IYR), Fidelity Real Estate Income (FRIFX), WisdomTree Emerging Markets Local Debt (ELD), TCW Emerging Markets Income I (TGEIX).
If you are happy with your returns on such investments, fine. But if you are looking for capital appreciation, gains or losses, you should get out now. The prices of what have been Treasury substitutes will fall as Treasury rates increase.
Table 6. - Performance of High Yield Investments
Source: Yahoo Finance
Bernanke made his ill-advised suggestion of tapering back in June. The right hand numerical column in Table 6 shows what happened to the S&P 500 and various Treasury substitutes' right after that statement. And while the S&P has recovered since then, the Treasury substitutes have not.
d. Higher US interest rates will draw a lot of assets from overseas meaning that foreign debt prices will fall and the US dollar will strengthen against foreign currencies. Foreign countries have hated QE because it makes their currencies stronger vis-à-vis the US dollar. This is bad for their export competitiveness. They will say hooray to a QE tapering.
e. A stronger dollar will cause overseas investments to lose value relative to US investments.
Again, they are Treasury substitutes. As Treasury yields become more attractive....So is this the time to invest in the US? Consider first what has happened to stock and bond prices since 2007 (Table 7).
US stock prices have grown rapidly since 2007. Are they near peaking? A commonly-used yardstick to address this question is the price to earnings ratio. Neither Reese nor McKinsey are concerned about its current level.
"The S&P 500's price/earnings ratio based on trailing 12-month operating earnings is 17.6; its forward P/E (using projected operating earnings) is 15.4. Those figures have been climbing, yes, but neither is indicative of major overvaluation. In fact, According to Charles Schwab's Liz Ann Sonders, those are both still shy of the 18.7 and 18.1 averages, respectively, for the past ten bull market peaks."
McKinsey questions whether equities and Treasuries are in fact substitutes. It doubts whether higher rates will serve as a real drag on stock market prices.
Foreigners have started to buy large amounts of US equities. In 2003, foreigners owned only $1.6 trillion in US equities. That number had increased to $4.2 trillion by 2012. Together, the total capitalization of NASDAQ and the New York Stock Exchange in 2012 was $18.7 trillion. That mean in 2012, foreigners owned 22% of US equities. My sense is that at least for the foreseeable future, foreigners will continue to buy US equities. Where else do will they get such growth with safety?
In sum, US equity investments make a lot of sense.
Concerns about higher interest rates are overblown.
- The Federal Reserve Board won't raise rates to gut the recovery. They will only raise them to curb inflation and to limit speculative "bubbles."
- An interesting question: given the apparent huge demand for Treasuries, will the Fed be able to get rates to rise, even if it sells a significant portion of its Treasury holdings?
- It is unlikely, even if the Fed can get rates to rise, that we will see a huge swing from debt into equity - the market for fixed income securities (mostly debt) is huge regardless of the rate.
The world is full of uncertainty. But there are a few things I believe are quite certain:
- The Greek-Eurozone conflict will not end well;
- The US zero-interest rate era will end soon.