Potholes on the Road (Part 2)

What else can go wrong? The economy seems to be chugging along, albeit at a modest pace. Is there something out there that could knock it off track?

One possibility is higher interest rates. Rates are at rock-bottom levels. Cash yields nothing. Short bonds yield almost nothing. To get a government bond yield equal to the average inflation rate of the last 10 years, you have to buy bonds that don’t mature for seven years—until 2018. To buy tax-exempt bonds that keep up with inflation, you have to go out 10 years.

These rates that punish savers make capital cheaper for borrowers. Top rated corporations can borrow 3-year money at 1% and can issue 30-year bonds at 5.5%. That makes it really, really easy to raise cash for new projects. That’s the theory behind the Fed’s ultra-low rates. But it also makes it easy to speculate, which may be one reason we’ve seen gold and silver prices zoom up and crash down. Oil has done the same thing. Lower rates may be having an impact on volatility.

So as the economy comes out of the doldrums the Fed is likely to bring rates back up to a normal level. If inflation is running at 2%, short rates should be there as well. Medium rates should be at 3%, and 10-year Treasuries at 4%. But this could depress stock prices. For one thing, if government bonds yield 3.5%, on average, they compete much more effectively with dividend-paying stocks. For another, they raise the cost of capital for corporations—by about 1.5%, on average. That may not seem like much, but it matters on the margin.

Higher rates might not derail the market, but they could take some steam out of the engine. Just one more factor to watch out for.

Douglas R. Tengdin, CFA
Chief Investment Officer
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