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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By |2014-09-12T10:47:37+00:00May 18th, 2011|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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