Rates leave investors rightfully cautious
Over the course of history, long-term interest rates usually have been higher than short-term rates. A 30-year mortgage will cost, say, 6 percent whereas a one-year adjustable rate mortgage will be priced at, say, 4 percent.
But over the past two years the trend has not followed the usual historical path. Short-term rates have been heading ever closer toward long-term rates. As the Federal Reserve has pushed short-term rates steadily higher, long-term rates have hovered around the same levels, stubbornly refusing to join their short-term counterparts in moving upward.
The result is that short-term and long-term rates have nudged ever closer. About two years ago, 10-year Treasury Bills were priced at 4.12 percent and 1-year Treasury Bills at 1.21 percent. Two weeks ago, 10-year Treasuries were 4.3 percent and 1-year Treasuries 3.95 percent.
Some money managers even talk of the rates as being on a “collision course.”
It’s easy to see why. With the short-term federal funds rate at 3.75 percent and the long-term 10-year Treasury Bond hovering just above 4 percent, it will take only one more quarter-point rate hike from the Fed to bring them within spitting distance of each other – if long-term rates stay where they are. And – again assuming long-term rates stay where they are now – two more hikes taking the federal funds rate to 4.25 percent could cause what economists call a yield curve inversion.
When short-term money is more expensive than long-term money, the difference can play havoc with the economy and historically such curve inversions have often led to recessions.
Another aspect of the interest rate increases is concerning some money managers. The Fed is raising rates because it fears inflation is of greater concern than growth and that higher rates will squelch inflation while maintaining reasonable economic growth. If the Fed proves to have been right, they will have engineered a soft landing, averted recession and proved the naysayers wrong.
Yet many managers believe inflation is tame and no reason exists to raise rates further. These managers see the risk as the Fed misreading the strength of the economy and that further hikes will create a recession. Investors’ views are reflected in the markets where five-year Treasury Inflation Protected Securities are predicting inflation over the next five years of around 2.5 percent – more or less the same level at which it has stood for a few years.
If the Fed is wrong and the market forecasts are right, therefore, this scenario also suggests that a steady rise in rates might push the economy over the brink into recession. So the real collision course is between investors who think inflation is tame and that Fed movements will choke off growth, and the Federal Reserve, which implicitly believes inflation is a problem but can be managed while growth remains reasonable.
Throw two damaging hurricanes into this mix and the picture becomes even more clouded. Many investors believe the resulting higher energy prices will sufficiently dampen the economy to make it unnecessary for the Fed to raise rates much further.
But the Fed has made it clear that it considers the threat of inflation a bigger one than the threat of a slowdown in the economy.
History also is not on the Fed’s side. Almost every time in the last 20 years the Fed has consistently raised rates – as it is doing now – the result has been a recession. It happened in 1993, in 1998 and in 2000.
As a result, investors – who generally look down the road six months to a year – are undecided about which way to place their bets. They are unsure what the economy might look like and, of course, do not know whether the Fed will be proven right or wrong and whether we will be faced with a recession or a soft landing.
Their uncertainty is reflected in a market that has essentially been going nowhere in the last few weeks.
For investors, the message is that now is not the time to tinker with your portfolio.