What is the Fed Doing?
The Fed has been taking its time raising the overnight or federal funds rate. This rate is used by the Fed to control the banking system’s supply of money. Lower rates translate into more money being lent and more money created. Typically, this would lead to inflation.
The Fed started its tightening campaign in December of 2015, with a 0.25% increase. It only raised one time in 2016, another 0.25% increase. 2017 saw three increases at 0.25% each. So far in 2018, we have seen two 0.25% increases and expect two more by the end of the year.
The target level for the federal funds rate currently stands at 1.75% to 2.00%, making the typical Prime Rate 5.00%. Most banks lend money at some derivation of Prime, either plus or minus some increment depending on the creditworthiness of the borrower. By the end of the year, the cost to borrow money will have gone up by 2.25% since 2008.
The Era of Free Money
From 2008 to 2015, the target rate was 0% to 0.25%, making that period known as the era of “free money.” Economic theory tells us that inflation should have crept into the system as the money supply boomed. However, the reality was different and the Fed was worried. Wage increases are the first sign of inflation. Yet, wage increases during this period were muted. The Fed took its time because the economy was still very fragile and any shocks could potentially spark a recession.
Inflationary pressures will cause the yield on the 10-year Treasury Bond to increase. The yield on the 10-year Treasury is currently around 2.85%. It was as low as 1.47% and 1.45% in 2012 and 2016, respectively. Those levels are historic. On the surface, it would seem as if the bond market was telling us that no inflation exists and will not surface. The reality is somewhat different.
The Role of Long-term Bonds
Other tools used by the Fed have held long-term rates down, such as buying long-term bonds and creating artificial demand for those bonds. Other central banks around the world were doing the same thing. The Fed is now, effectively, a seller of long-term bonds as it lets its maturities roll off without replacing them.
In addition, the U.S. Treasury has significantly increased its issuance of new debt as the U.S. budget deficit continues to widen. All of these factors would typically point to long-term rates increasing. Rising long-term rates are restrictive for home buyers as 30-year mortgage rates are tied to the 10-year Treasury.
Why Aren’t Long-term Rates Going Up?
Investors buy long-term Treasuries when there is fear in the markets. When there is more demand for bonds, their yields go down. Global tensions have halted the rise in yields. The yield rose as high as 3.14% in May. Since then, tensions have been high over tariffs and a potential currency crisis in Turkey. There is some fear in the stock market and we see that reflected in the bond market.
We don’t think that the current yield on the 10-year Treasury is realistic considering all of the factors we previously noted. Headline CPI, a common measure of inflation and the gauge used to adjust many payments such as social security, is running about 2.9% and will only go higher as tariffs start hitting consumers in the pocketbook. Wage inflation is slowly picking up, running close to 3.00%. All of these factors lead us to believe that long-term rates will be heading up in the near future. The market gets more nervous with each release of the employment report, the first Friday of every month. We feel a more realistic level for the 10-year Treasury would be closer to 4.00%.
What Does This Mean for the Stock Market?
Inflation is not necessarily a bad thing for stocks. If growth can keep pace with inflation, they cancel each other out. Spikes in interest rates are bad things for the stock market. The quick way to value a stock is to compare the expected stream of income or growth in value with what you could otherwise get from a risk-free 10-year Treasury.
As yields increase on the Treasury, stocks may become less attractive if there is not growth to offset the calculation. As long as inflation and/or long-term rates do not spike, we are comfortable with the Fed’s actions and the overall level of the stock market. The road to 4.00% long-term rates looks slow and steady from here, but any market participant knows, surprises can happen at any time. The best way to prepare is to ensure that your level of risk tolerance is matched up with your portfolio allocations.