Interest rates

What’s going on with interest rates?

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Last month I wrote When Stocks and Bonds Won’t Enoughsummarized as follows:

  • Interest rates rise, so bond and stock prices fall.
  • You can ride it, but it might be a terribly long and difficult journey.
  • The other option is to exit stocks and bonds and either (1) hold other assets or (2) hedge your stocks and bonds

This month of July 2022 has egged my face so far. Interest rates actually went down and the alternatives I recommended suffered serious losses.

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Target date solutions

Apologies to anyone who has followed my advice so far. But let me explain.

The world wants US dollars

In Fed Rate Hike: Why Are Bond Yields Falling? Schwab chief executive Kathy Jones says the strengthening U.S. dollar has pushed foreign investors into U.S. stock and bond markets, causing U.S. interest rates to fall rather than rise.

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Bloomberg

The source

Bloomberg

Yin and Yang

But the article acknowledges that ‘quantitative tightening’ could eventually lead to interest rate hikes as the Fed reduces its manipulation of bond prices, potentially pushing 10-year interest rates back to the 3.5% hit. end of June according to the author.

I believe interest rates can and will exceed 3.5% to reach a historical norm of inflation plus 3%, or 12% in our current inflationary environment of 9%. “Quantitative tightening” is the opposite of “quantitative easing” (QE) and is also called “tapering”.

QE is a manipulation of bond prices with the aim of keeping interest rates low. Tapering allows the Fed to lift the brake on interest rates. In addition to raising short-term interest rates, the Fed announced that it will also lower by allowing the bonds it holds to mature without replacement. And the Fed’s balance sheet has begun to slide below its all-time high of $9 trillion. It is actually tapered.

Tapering will reduce stock and bond prices

Without Fed intervention, bond prices will seek a fair market price. It appears that foreign demand is currently inflating these prices, mitigating the effects of tapering. But risk-reward pricing will eventually prevail. As the following pyramid shows, bonds have historically yielded 3% above the rate of inflation.

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Crestmont

Rising bond yields will impact equity markets in several ways. Bonds will once again become attractive alternatives to equities. In addition, future stock earnings will be discounted at higher rates, which will reduce the fair value of the stock.

Conclusion

My June prophecies turned out to be wrong, but it’s only been a few weeks so far. I remain convinced that it will be extremely difficult to control inflation and that inflation will burst the current bubbles in the 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 so is Russia.

The inflationary problems of the United States will not go away quickly. After all, we’ve printed over $13 trillion in the last decade. More soon.