When 24/7 Wall St. ran its 10 serious risks that could wreck the raging bull market in stocks, a quick rise in interest rates was one of those risks. Now rates have started to rise at the onset of 2018 and what was the best start of the year since the 1980s for stocks suddenly has run into some pressure. Investors probably should not lose sleep over what has been seen so far in the rising interest rates, but they sure better not bury their head in the sand and ignore it.
Whether you believe that China really will start backing away from Treasury notes and bonds is up to you. Frankly, that story seems trumped up and likely would be a negative for China, close to as much of a negative as it would be for the United States. One issue that will continue to pressure longer-term interest rates is the impact of tax reform on the corporate side of the economy — taxes dropping from 35% to 21%, immediate expensing and even the trickling down of higher wages and bonus checks.
Another reason that investors might not need to overly worry about interest rates at this point is that there is an inherent conflict of interest. If the Fed raises interest rates too much then it is in effect forcing the government to pay more in its debt servicing costs rather than spend the money directly back into the economy. Take this into consideration with $20 trillion in debt: if the Fed were to drive up rates a theoretical 1% across the board, that would drive up the cost of debt financing by another $200 billion per year. That is a serious number, and it is not what any of the forecasters have been using for long-term debt accrual expectations.
Higher inflation is another threat to interest rates, although inflation has yet to get out of hand. If tax reform is going to boost business massively, then continued price hikes and wage hikes could start to be more of an inflationary risk than what we have dealt with in recent years. The Treasury 30-year yield is now closer to 2.92%, still far short of that key 3% hurdle.
24/7 Wall St. recently released its forecasts for 2018 to its email distribution list. On interest rates, our message may sound simple enough on the surface:
Most investors use the yield of the 10-year Treasury as the benchmark against equity yields. That being said, The S&P 500 was valued at roughly 19 times expected 2018 earnings. The 10-year Treasury’s yield of almost 2.6% is already some competition for equity investors, but now yields are up higher in the two-year and five-year Treasury notes too. The five-year yield is 2.34% (versus 2.21% at the end of 2017) and the two-year yield is now 1.97% (versus 1.89% at the end of 2017).
Now that Jerome Powell is set to replace Janet Yellen as chair of the Federal Reserve, it is also expected that he will not want to raise interest rates endlessly. President Trump has been a fan of lower interest rates due to the economic advantages, and Powell’s appointment is deemed to be a status quo chair at this time. That could change, but that’s where it is now.