What Is Going On With Interest Rates?

Holding all the answers to your questions

Goodboy Picture Company/E+ via Getty Images

Last month I wrote When Stocks and Bonds Won’t Do, summarized as follows:

  • Interest rates are going up, so bond and stock prices are going down.
  • You can ride it out, but it could be an awfully long rough ride.
  • The other option is to move out of stocks and bonds and either (1) hold other assets or (2) hedge your stocks and bonds

So far this month of July 2022 has put egg on my face. Interest rates have actually decreased and the alternatives I recommended have suffered serious losses.

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Target Date Solutions

My apologies to anyone who has taken my advice so far. But let me explain.

The world wants $US dollars

In Fed Rate Hikes: Why Are Bond Yields Falling? Schwab Managing Director Kathy Jones explains that a strengthening US dollar has driven foreign investors to US stock and bond markets, causing US interest rates to decrease rather than increase.

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Bloomberg

source

Bloomberg

The Yin and Yang

But the article acknowledges that “quantitative tightening” could eventually result in interest rate increases as the Fed reduces its manipulation of bond prices, potentially raising 10-year interest rates back to the 3.5% reached at the end of June in the author’s opinion.

I believe interest rates can and will blow way past 3.5% on their way to a historic norm of inflation plus 3%, which is 12% in our current 9% inflationary environment. “Quantitative tightening” is the opposite of “quantitative easing” (QE) and is also called “tapering.”

QE is manipulation of bond prices with the intention of keeping interest rates low. Tapering is taking the Fed’s foot off of the interest rate brake. In addition to increasing short term interest rates, the Fed has announced that it will also taper by allowing the bonds it holds to mature without replacement. And the Fed’s balance sheet has begun to decrease below its all-time $9 trillion high. It is in fact tapering.

Tapering will reduce stock and bond prices

Without the Fed’s intervention, bond prices will seek a fair market price. It seems that foreign demand is currently buoying up those prices, mitigating the effects of tapering. But risk-reward pricing will eventually take hold. As shown in the following pyramid, bonds have historically yielded 3% above the rate of inflation.

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Crestmont

Rising bond yields will impact stock markets in a couple of ways. Bonds will once again become attractive alternatives to stocks. Also, future stock earnings will be discounted at higher rates, reducing fair stock value.

Conclusion

My June prophecies have proven wrong, but it’s only been a couple of weeks so far. I remain convinced that it will be extremely hard to control inflation and that inflation will burst the current bubbles in stock and bond markets.

The strengthening of the US dollar is relative, and the result of being “the cleanest dirty shirt” in the laundry basket. The rest of the world is suffering the economic consequences of COVID and Russia too.

The US’s inflationary problems will not go away quickly. After all, we’ve printed more than $13 trillion in the past decade. More to come.

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