Rates Govern Finance, May Have Just Reversed
I think the single biggest factor governing a winter mountain expedition is the weather, and the biggest weather factor is the wind. A 105 MPH gust will throw a 200 pound climber like a leaf, forcing the humiliating crawl. An 80 MPH wind will cause such exertion staying vertical that exacerbated breathing can freeze the goggles, a potential deathblow. The wind is always a primary concern for mountaineers, not only direction and velocity now, but where these forces may be in an hour, and every attempt to move on the mountain evaluates them. If there is a single comparable governing factor in finance to the mountain wind, it is interest rates. Rates represent the cost of capital, and capital is the lifeblood of every financial entity; your family is a financial entity. Rate assumptions factor into computing the time value of money, so every decision pertaining to any use of capital is impacted by interest rates, at all levels. In a highly indebted society, the impact rates have on finance is even more dynamic. So where are interest rates heading, and what are the primary implications?
Following one of the most aggressive inflation-fighting, rate-hike campaigns in the Fed’s 110 year history in 2022 and early 2023, the recent failure of Silicon Valley Bank caused a stampede of capital into the largest perceived safe-haven asset on earth, U.S. Treasury Bonds. Frenzied buying caused the rate on the closely watched 2 Year T-Bond, which peaked at 5.07% on March 8, 2023, to crash to below 4% in just three trading days, one of the biggest three day drops on record.¹ I liken the drop, which has occurred only ten times in fifty years, to a sudden calm in the midst of sustained 90 MPH mountain winds! All ten of these occurrences took place in the 1980’s, and consistently indicated a reversal in the direction of rates. Any remaining contagion from recent bank failures likely means additional concentrated demand for T-Bonds, which would further reduce rates. Economic weakness associated with the oncoming recession would apply further downward pressure. These factors, combined with the fact today’s 5% Fed Funds Rate is the highest in 15 years, suggest rates may be reversing and can drop significantly from here.²
We’ll be wise to consider the implications of falling rates:
The U.S. dollar will likely weaken against foreign currencies, and especially against real assets.
Recent declines in price inflation may moderate, and inflation may resurge.
Existing bond values may rise as new bonds offer lower yields, especially those with longer maturities.
Investors who recently bought 2-3 year T-Bonds look smarter than those who bought 3-12 month T-Bills.
Gold, which pays no interest, may look more attractive as compared with treasury bonds, and could get an additional “push” from resurging inflation.
Stocks may come under pressure initially as the capital ‘flight to safety’ plays out, but ultimately lower rates tend to push stock prices higher.
The Fed is trapped between fighting inflation, which is far higher than its desired 2%, by raising interest rates, and fighting crises instigated by those rate hikes. There is no indication the Fed will escape this trap anytime soon.
Given the shortage of homes in America, residential real estate may find a footing and recover with a reduction in interest rates.
Think about it, Shaun.
“A slack hand causes poverty, but the hand of the diligent makes rich.”~ Proverbs 10:4 ESV
1,2 Daily Wealth, “Market Turmoil Could Signal a Top in Interest Rates”, by Brett Eversole, March 28, 2023
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial.
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