The Cornerstone

July 2013

“The Path to Higher Rates”

  Higher Rates-This is a story or perhaps just a preview of what we have been talking about for a long time.  The difference is that there are a few nuances that in my opinion make the story a little different: First, I don’t believe this is a change in policy – Ben Bernanke and the Federal Reserve still believe very much in providing liquidity and  easy money right now, but are simply now illuminating their thoughts.  The Fed was always going to move rates up eventually, and phasing out QE by next summer is very reasonable.  Though it is necessary, it is a large move, and a large amount of money to move out of the system.  This could be potentially disruptive in the short-term, but with the shrinking deficit and the economy growing, the poorer choice is to continue the QE program indefinitely. Secondly, higher interest rates are inevitable, but I think there will be no long-term detrimental effect on stocks.  While this has not been the effect recently, I think it’s because the new uncertainties of higher rates on the economy and stock prices have sent some investors into hiding.  The economy, though not super energetic, looks pretty good right now and the economic numbers seem to be supporting this and going in the right direction.  A return to more normalized interest rates should actually give confidence to the economy and markets. Third: I don’t think that bond market has over reacted.  The recent rise and expected higher rates to come are not a surprise.  Yes, they did move up quickly, but the absolute numbers may still be even a bit too low.  Consider that over the last year the rate of inflation is about 1.7% and the current 10 year Treasury as of today is just 2.65% (just 95% difference between the two!). Using historical spreads, the 10 year Treasury should be closer to 4%, if not more.* Fourth – After this recent correction, equities are relatively undervalued to bonds than they were. Is this uncertainty?  I would argue there is more certainty but the rub may be that Fed has been justifying the QE program for the last few years, telling us that the economy would be horrible if it wasn’t there.  So when the possible tapering announcement came, investors became frightened and sold equities not believing that they can ride the bike without training wheels.  We should get used to it; I don’t think we’ve seen the end of higher rates. Fifth – The economy is moving forward first of all because of the prices of homes.  They are going up, not because of mortgage rates being low, rather because there is not enough supply.  Autos sales are in the same boat, as are airlines, and occupancies for hotel rooms and apartments.  The increase in interest rates convinces people that the economy is OK.  This in turn puts a fire under them to get things done, and make major purchases before they are too expensive or interest rates get too high. So don’t be frightened by the news – sentiment always gets hurt in a pullback as the economy rebalances itself and I think waiting for a better day to buy is a good way to be left behind. As always – Thank You Very Much for Your Business! Phil The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  Stock investing involves risk including loss of principal.  Past performance is not indicative of future result.   Indices are unmanaged and cannot be directly invested into. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. *Bloomberg market data sheet7/5/2013.