The following article is presented courtesy of Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.
The Fed is expected to raise short-term rates in a very gradual fashion beginning next year, and five or so years from now rates are going to be topping out around 3½ to 4%.
There’s nothing very scary about this. As the graph below shows, for most of modern history 5-yr Treasury yields have traded well in excess of 3%. That 5-yr yields today aren’t expect to rise above 4% for as far as the eye can see is pretty unusual from an historical perspective.
Interest rates aren’t expected to rise by much because:
- the market doesn’t think the U.S. economy has much chance of returning to its former growth glory, and
- the market doesn’t think that inflation has much chance of exceeding 2-3%.
In other words, the bond market today seems fairly convinced that growth will be sluggish and inflation will therefore be tame for as far as the eye can see.
- if you see more potential for growth and inflation, then bet that rates will rise faster than expected:
- lock in long-term borrowing costs today;
- keep the duration of bonds you own as short as possible; and
- avoid excessive leverage (or place hedges to protect against higher-than expected borrowing costs),
- consider an increased exposure to real estate, since it should benefit from stronger growth and higher inflation, and it is not necessarily expensive today and
- also consider an increased exposure to equities, since stronger growth and higher inflation should have a positive impact on future expected cash flows.
For my part, I acknowledge that I have been overly concerned about rising interest rates for most of the past 5 years or so. Being wrong for so long is humbling, but it is not a reason to shy away from worrying about a faster-than-expected rise in interest rates today. In the end, it’s all about what happens to the economy and to inflation.
I’m still an optimist on the economy, since I think the market’s growth expectations are overly pessimistic. I think 5-yr real yields on TIPS tell us a lot about the market’s underlying expectations for real economic growth.
As the graph above suggests, the current -0.38% real yield on 5-yr TIPS points to economic growth expectations of perhaps 1% per year, which in turn is a bit less than we’ve seen in recent years. If the market were convinced that future growth would be a solid 3% a year, then real yields today would be a lot higher than they are now.
I’m still more worried about inflation than the market is, since I think the market is being a bit too complacent about the inflationary potential of the Fed’s massive balance sheet expansion and the Fed’s ability to reverse course in a timely fashion.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
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