Interest Rates

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Interest Rates & Inflation 

The fundamental relationship that is widely accepted today—that interest rates, particularly long-term rates, are directly affected by the rate of inflation—was not apparent during the first two-thirds of the past century. This creates significant implications for the use of historical interest rates prior to the 1960′s…or casts doubts to the relationship between interest rates and inflation.

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The 6/50 Rule 

In the past 45 years (with a two-month exception in early 1998, one week in April 2006, Sept to Nov 2006, two weeks in July 2009, six weeks near the fourth quarter of 2011, and the last three weeks of 2012), there has not been a 6-month period during which interest rates did not change at least 50 basis points-interest rates are much more volatile than most investors realize. As history demonstrates, almost half of the time, interest rates change by more than 1.5% (and over 25% in percentage terms) over all 6-month periods. This set of charts and statistics (a total of five pages) presents the data and a boundary guideline that can be expected to be crossed over the next six months.

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The 10-Year Treasury Note 

The 2003 rise in the interest rate on 10-Year Treasuries (and related decline in bond prices) was dramatic. This historical analysis presents the change in the yield on the 10-Year Treasury within subsequent 8-week periods. The magnitude of the move in percentage terms is much more significant than the change in absolute terms. Although there have been a number of 1% (100 basis point) changes in interest rates, this was the first change in rates of more than 30% of the starting interest rate level. Since then, the decline in volatility across many financial markets has occurred in the Treasury Note market too.

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The Yield Curve, The Fed, & P/Es 

The upcoming interest rate increases by the Fed should preserve stock market P/Es, not impair them…unless they’re not successful in controlling inflation or drive us back into deflation. The increases in short-term rates are intended to contain inflation, the driver of P/Es and long-term interest rates, at levels of price stability. The implication of a 100 basis point (1%) yield spread is that the interest rate that affects stocks, the long-term rate, is likely to stay relatively low. Why? This analysis presents the answer and the likely reason that PIMCO is buying bonds.

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Bond Yields: Reasonable Expectations 

Is 3% on the 10-year Treasury note high, low, or just about right? The Fed appears to be targeting inflation between 1% and 2% (although that commitment is quite certain). By adding a 2% inflation-risk spread, 3% or lower may be just about right for the 10-year note.

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Dynamic History 

Take a tour of interest rates, financial indicators, and markets over the past century. This model reflects the history of interest rates in the 20th century. The model dynamically presents the yield curve across each year of the past century. The yield curve is the graphical depiction of interest rates across maturities from one to twenty years. Short-term rates are often different than longer-term rates and the level of interest rates has changed over time. In addition, the model provides an historical perspective on inflation, economic growth, and stock market changes.

If you choose not to enable the macro that provides a dynamic display over time (look for the “Start” button in the upper right corner), you will have manual control over the progression across the century (in the lower left corner). Look for instructions in the lower right corner. Three versions are provided depending upon your screen resolution (a larger size is recommended).

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Climb the Ladder 

Fixed income investors have been paralyzed by the fear of rising interest rates. Many investors have elected to hold cash rather than to reinvest farther out on the yield curve in maturities that offer higher interest rates. Bond market pundits are calling for higher interest rates in the near future (keep in mind that most are providing perspectives consistent with the past twenty years, when inflation was being controlled downward by the Fed, rather than in an environment with the conditions that exist today). Although an immediate rise in interest rates does cause a decline in the value of bonds, the loss of higher yields while waiting for better prices can be significant. This analysis of historical interest rates shows that simple bond ladders, particularly maturities of 10 years and less, did not experience annual losses anytime over the past century. A simple bond ladder may be one of the best approaches for fixed income investing as the potential for rising rates looms. A bond ladder is a portfolio of bonds with a portion of the portfolio maturing each year (often equal amounts across each annual maturity). A bond ladder can be as short as two years or as long as 30 years or more.

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Surfing The Roll 

The yield curve reflects the interest rate relating to each maturity year presented on a graph. Since long-term interest rates are generally different than short-term interest rates (normally longer-term rates are higher), the graph has a slope or curve to it. This analysis presents an assessment of the impact of buying a bond and enjoying the built-in appreciation that occurs as a normally higher interest rate bond becomes a valuable shorter-term bond (the “Roll”). Obviously, changes in overall interest rates affect both positively and negatively the impact of “rolling” down the curve. However, this dynamic provides some built-in protection against the adverse impact of rising interest rates and helps investors that want to increase the yield of their portfolio by investing in longer maturity fixed income securities (bonds).

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Grossly Misunderstood Debt 

The often cited chart, by Bill Gross and others, reflecting a surge in Total Credit Market Debt as a % of GDP is distorted by a number of factors. One of the most significant reasons is that many families have substituted mortgage payments for rents and, without changing their costs, increased the debt ratio. Ironically, the shift built significant equity value. Further, when the long-term series is viewed on a standard logarithmic scale to show percentage gains over time, the chart becomes much less dramatic. On a real basis, adjusting for inflation, the rate of growth has been relatively constant over the past 50 years.