A low interest rate environment has been a key catalyst to the rise in stocks since the last recession. The overall trend in rates has been down but hit an inflection point a little over a year ago when the Fed announced it was going to begin the process of reducing the size of its balance sheet. Not surprisingly, since then stocks have been more volatile than they were in the several months and even years leading up to the announcement. Granted, other factors have surely contributed to stock market volatility since then but I don’t believe it’s a coincident that a meaningful inflection point in interest rate trends and increasing stock market volatility are occurring at the same time.
As we sit here today, the trend has been much more pronounced in the short-end of the yield curve, which isn’t all too surprising given the Fed induced upward pressure on shorter-term rates. That said, since August 24th of this year, the 10-year yield has increased 13% (37bp), similar to the increase witnessed earlier this year. What’s clear from the charts below is that the short- to medium-term trend is now up after being in a downtrend for a number of years.
Naturally, the question now is whether the move up in rates is simply a late business cycle phenomenon and, thus transitory in nature, or does the move up have longer lasting elements that will outlast the current cycle?
To answer that question, we need to attempt to identify the potential causes of the increase in rates.
Transitory Factors
The typical late cycle phenomena that tend to push rates higher include above trend GDP growth and high capacity utilization. GDP growth is now in fact above trend while capacity utilization is kind of high for this cycle but not by historical standards.
These factors have likely contributed, at least in part, to the rise in rates.
Higher prices could also be contributing to the rise in rates. Rising prices are also a late cycle phenomenon but there is the added element of trade conflicts and tariffs this cycle that may continue to have an impact on rates beyond the current business cycle. In the chart below, it appears real rates are having more of an impact on rate increases than inflation expectations.
The move up in real rates (TIPS) is clearly more pronounced than in inflation expectations.
There is a lot of anecdotal evidence the trade conflict/tariffs are putting upward pressure on prices. Companies have begun acknowledging the impact on pricing as well although it’s not entirely clear that price increases have been passed along to consumers. I would expect inflation expectations to eventually reflect the reality of price increases being passed on to consumers if they don’t already.
Not So Transitory Factors
Two other factors that are likely putting upward pressure on rates are the Fed’s shrinking balance sheet and U.S. government’s funding needs going forward. It’s difficult to quantify the impact both of these factors might have on rates but the WSJ had a piece in today’s paper discussing the rising term premium, suggesting the flip in the supply/demand dynamic (the Fed being an effective net seller vs. a net buyer) could lead to the term premium continuing to increase. The premise makes sense intuitively as the equilibrium in the bond market has been artificial at best with the Fed’s involvement over the past decade. My personal feeling is the Fed’s shrinking balance sheet will likely result in upward pressure on rates although it may end up being immaterial.
The federal government is going to have to issue over a trillion dollars over the next year to fill the funding gap. Unless growth picks up meaningfully and revenues increase accordingly (or spending is cut), it appears there will be ever increasing funding gaps to fill. Budget deficits are nothing new but when coupled with an increasing debt load will likely at some point lead to upward pressure on rates. What the break point might be is anybody’s best guess.
Summary
In summary, above trend GDP growth and rising capacity utilization are transitory and their impact on rates will diminish during the next recession. The impact of higher prices on rates will likely fade as well to the extent their current levels are business cycle related. However, higher prices resulting from tariffs will likely last beyond this business cycle and into the next unless they are removed. The Fed’s shrinking balance sheet and expected future federal government deficits (not to mention state and local government deficits) will most likely result in upward pressure on rates beyond the current business cycle.
Parting Thought
An argument can be made that the long-term downward trend in rates has inflected and we’re at the outset of an uptrend. The building blocks for such a new trend appear to be in place. However, all of the aforementioned factors may end up being transitory in nature or may be overridden by stronger drivers such as demographic trends and other currently unknown factors.
