February 26, 2021
It was way back in October that this blog highlighted that it was A Little Early to Worry about rising interest rates, but here we are, almost exactly six months later and it is no longer too early to worry.
Over the past two weeks, the market has gone through unsettled and is now full on worried . . . perhaps a little bit far off of panicked. The declines in indices is notable, but more notable is what indices should look like in a rational world.
Below is a chart showing the 10 year treasury yield with the S&P 500 Index value overlaid. Pay attention to the green circles.
There are four times in the past 10 years when the 10 year treasury yield was at or around the current level (1.55%). Looking at the value of the S&P 500 at those points in time may offer some insight into what stocks could be trading at. Let’s look closer:
- May 2012 – around 1,300
- June 2016 – around 2,100
- August 2019 – around 2,900
- February 2020 – around 3,400
Currently the S&P 500 is around 3,800 and so substantially higher than most of those other periods. Objectively, the market has moved higher after each of those periods, as interest rates rebounded to higher levels (typically around 3%). These were periods where economic activity was strengthening AFTER a drop in rates to this 1.5% range.
In the current situation, the economy is also arguably strengthening, however rates have already tripled from their lows and may move much higher as economic activity spurs inflation. Of course many commentators are speculating that the move is too fast and that the rates will reverse course. I speculate that is not the case, at least not in a reasonably long time frame. (Think two years or more.)
This rise in rates may not last long, and rates may not rise much beyond the current level while the economy suffers massive dislocations due to COVID, but we know that interest rates can’t really go lower. When they do, all of the money goes into the stock market, because there is no alternative (TINA). Put another way, rising rates mean that investors have an alternative to expensive and arguably risky equities, real estate, and more. Arguably bonds offer a guaranteed return on your capital while equities are statistically unlikely to rise much farther based on historical valuation norms.
The past year has brought a lot of these economic arguments to a stop. With massive stimulus supporting the economy and more on the way, economic metrics are almost meaningless. But as the impact of COVID wanes, as governments reach the end of their stimulus funds and as restrictions are removed for larger portions of the economic landscape, money will be more scarce, and funds will be looking to reduce risk or simply take profit.
There are other options! Asset prices can continue to rise. Central banks can keep flooding the market with liquidity, consumers can increase spending, automation can improve productivity. But these have not been improving economic output for a long time. Still, asset prices may be saved by some new and ingenious accounting or economic magic.
Just in case . . . worry is something that you should certainly do at this point.
Before signing off, it is worth noting that jobless claims are still massive. While they have improved a lot over the last year, they are still much higher than in the worst of the Great Recession of 2008. Despite that, markets are close to all time highs and many consumers and businesses have been granted some protection by various government entities for housing, food and more. When it comes to an end, there are a lot of people who are going to be in trouble.