Interest Rates Rise at 2652% Annualized Rate!
That's probably a headline you will not see in the Wall Street
Journal and it's certainly a bit over the top, but those are the
facts. From July 18 to August 17, the interest rate on the 2 year
Treasury jumped from .22% to .29%. That's a 32% one month increase
and works out to an annual jump of 2652%, if you compound the
increase monthly. Just to be fair, the 10 year rate "only" rose
from 1.52% to 1.81% or about 19% over the same period. With the
magic of compound interest, that generates a far more benign 713%
annualized rate rise.
If you haven't already done the math, those growth rates would
take you to a 43.8% annual interest rate on the 2 year in one year
from now, and a 12.9% interest rate on the 10 year at that point.
Of course, that is not going to happen. Most likely we've just seen
a random fluctuation in an overbought market. The Fed has promised
to keep interest rates low for an extended period, after all.
We've been saying for some time
that the seeds have been planted for a move into a period of
stagflation comparable to what we saw from the mid-1960's and the
1970's. That move, which transformed the benign inflation of the
1950's to a raging inferno by the end of the period, eventually
took Treasury rates for the 10 year to unheard of levels of 15% by
the end of the 1970's. This resulted in a collapse of the bond
market and the eventual failure of the entire savings and loan
industry in the United States in the 1980s.
The United States and most of the developed world have benefited
tremendously over the past 30 years from a steady drop in long-term
(click to enlarge)
Source: The American Enterprise Institute
Even the potential for a small retrenchment in this extended
bull market would have highly negative consequences for the global
financial system. The world has changed dramatically since the
1970s in some critical respects. In the United States, total public
and private debt as a percentage of gross domestic product more
than doubled from 150% in 1965 to a peak 384% in 2009. Other
economies such as the U.K. and Japan have even higher debt ratios.
As a result, the financial system is far less stable than it was in
the 1970s and far more subject to external shocks. When/if the
period of benign interest rates ends, there is significant risk
that rate moves will be far more violent and far more rapid than
experienced in the 1970s.
The other critical factor that differentiates the current period
is that global financial institutions are far more leveraged and
interconnected than they were in the earlier decades. The current
yield curve is a historical anomaly. With inflation averaging
between 1.4% and 3.2% in 2011 and 2012, long-term Treasury bonds
should not be trading anywhere near their current levels. As an
example, the 10 year traded to yield 1.82% on August 17, 2012. By
comparison, the 10 year traded to yield 5.40% on August 17, 1998, a
year in which inflation averaged 1.6%, close to the July 12 month
CPI print of 1.4%. On August 16, 2002, another year in which
inflation averaged 1.6%, the 10 year yielded 4.32%.
These data points, indicating an expected yield premium for the
10 year of 270 to 480 basis points over the inflation rate, fit
with many decades of observed market behavior. The
from Avondale Asset Management indicates a wide variation of this
spread over time, but with a bias toward a spread of 200-400 basis
Crestmont Research found
a similar behavior for the 20 year, with an average spread over
multiple decades of 2.9%
(click to enlarge)
A combination of global quantitative easing and capital flight
to the few currencies and markets perceived as strong, has enabled
the Fed to maintain a historical anomaly in long-term rate
behavior, and the market clearly believes that the Fed will
continue to do so.
Without considering the possible impact of an increase in
inflation on long-term rates, what if 10 year interest rates were
just to move from their current levels to a more normal, but
conservative 250 basis point premium over inflation? That would put
the 10 year at 3.9%, implying a price drop for the 10 year bond of
a bit over 9%. An average 290 basis point spread for the 30 year
would result in a price drop for the long bond of 21%.
What does that imply for the financial markets? Despite ample
evidence to the contrary, financiers in every cycle assume that
they can beat the odds by borrowing short to lend long. That's what
killed the savings and loans, and similar investment patterns had
been responsible for numerous other financial crises.
While risk managers and regulators understand the risks very
well, it seems highly unlikely that somewhere within the financial
system, bondholders are not succumbing to the temptation to take
advantage of the arbitrage of 0% short-term rates against higher
long-term rates. We know this is happening because hundreds of
billions, perhaps trillions of dollars of mortgages have been
refinanced as 30 year fixed obligations at very low interest rates.
Someone is taking that long-term risk. Certainly much of it is been
taken by the Federal Reserve through Operation Twist and other
mechanisms, but almost certainly a meaningful portion of the term
risk has been assumed by highly levered financial institutions and
A likely method of transmission for this risk is the interest
rate derivatives market, where total nominal exposure by U.S. banks
was $183 trillion, with approximately 93% held by just four banks
at the end of Q1 2012. With some large financial institutions' Tier
1 capital ratios still below 10%, a 9% swing in a material portion
of their asset portfolios could have a significant earnings impact.
For the economy as a whole, were such a move to occur quickly, it
would constitute a Black Swan event at least as significant as that
experienced in 2008.
As I write this, it's a gorgeous August day. After 2 months in
the high 90s and 100s, it's 83°. This happens most years and I know
that we're still in for quite a bit of hot weather between now and
fall. But this taste of cool weather provides me assurance that
fall is coming. I'm not predicting that a one month of volatility
in the bond market will inexorably lead to a rapid move up in
interest rates. However, like this gorgeous August afternoon,
prudent investors should consider the possibility that the past
month is a foretaste of a likely change in weather down the
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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