Since July, the benchmark interest rate, the US 10-year treasury bond, has risen from 1.35% to over 2.55%. That’s a very big move in a short-period. Post-election day the rising rate trend accelerated. We saw a similar spike in 2013, only to see rates retreat. Is it different this time?
Valuation Building Block
Markets seem to believe that current rates are sustainable and can keep rising given the lower tax and infrastructure spending pronouncements coming from the new president elect. Interest rates are building blocks in asset pricing. Generally, when rates change business, individuals, and investors will re-examine their assets and shift them around to reflect their risk and return preferences. The expectations for changes in asset prices can take on near-term speculative fever: “Wait, I need to buy before it gets more expensive!” or “Wait, I need to sell before this thing tanks!”
Stability vs return; fear vs. greed (the two emotions that drive market prices). What return can you expect on your investments – be they stocks, bonds, real estate, or a business? It’s seldom a simple calculation. If predicting financial markets were only about numbers, math professors wouldn’t need to profess!
Since the election, US equity markets have climbed and bonds prices have sunk. Bonds reaction to rising rates is predictable. Bonds are “fixed-income” meaning its coupon rate remains the same regardless how interest rates move; however, when rates rise bonds lose market value because newly issued bonds have higher coupon rates, hence more value to you.
Will the Trump rally continue its ascent? Investors will eventually begin the stability vs. return tug of war. The Federal Reserve announced its intention to raise rates three times in 2017. This may or may not materialize. However, if bond yields do rise, many will trade bond stability over higher, more volatile equity returns which could create less demand and lower prices for equity – both public and private.
Is the “New Normal” Fading?
The “new normal” camp sprang from the 2008-09 crisis. Proponents argued that an aging U.S. population and high debt levels would bring on a Japanese style deflationary environment; and that technology and automation would depress middle-class wages and reinforce lower price trends. In fact, wages have stagnated for over 10 years and rates have stayed historically low. The long-term average on the 10-year treasury bond is 5%; even with the rapid rate rise since July, we are still at half the long-term average.
On the other hand, lower prices spur consumption; and wages have started to show some improvement. Add some fiscal stimulus, a deregulatory minded White House, and government spending: Boom – Keynesian animal spirits will prevail!
However, a few wild cards worth considering: will political rhetoric be matched with real action that might incite a trade war? Will lower taxes and government spending on infrastructure spur growth without impacting the U.S deficit? Will financial reform of Dodd-Frank create the same mess that brought us to Dodd-Frank?
These type considerations will impact our domestic economy and the business environment. Low rates have helped prop up equity valuations, made real estate more affordable, and allowed businesses to lower their capital costs. Rising rates may create a headwind.
Risk of Return
Indeed, rate increases mean the cost of capital is going up. We business appraisers use the “build-up method” which begins with the US Treasury rate and “builds up” a required rate of return based upon various risk factors. If the rise in rates is accompanied by higher growth in revenue and profit, valuations can remain high. However, if rates climb, growth stagnates, or inflation eats into profits, it most likely will have a downward push on business value (both public and private markets).