Will Rising Interest Rates Cause Problems For Stocks?

Interest rates are a very significant factor for almost every asset. For
example, as interest rates decline, every other asset becomes a little more
attractive than cash. As interest rates rise, every other asset becomes a little less
attractive. On the other hand, when interest rates rise off of a very low level, as is
the case now, it is sign that the economy is improving. If the economy is
improving after going through a difficult period, higher corporate profits can more
than compensate for rising interest rates. When rates have increased when they
were below 5% in the past, it has not really been a problem for stocks.

History also shows that rising interest rates, on their own, do not cause serious
problems for stocks. What has caused problems is when short-term interest rates
are higher than longer-term interest rates. Normally, the interest rate for shorterterm
bonds and mortgages are lower than for longer-term bonds and mortgages.
So, when short-term rates are higher than longer-term rates, the situation is the
opposite of what it usually is. That is why this is called an inverted yield curve. In
the past, an inverted yield curve has been one of the best signals that a recession
should occur a year or so in the future.

Recently, the yield on 2-year US government bonds were higher than the yield
on 10-year US government bonds. (The 10-year bond is usually used as the
benchmark for the yield on longer-term bonds.) Please see the following two
pages for some of the headlines that Reuters published when this happened in late
March.

The chart from FRED (Federal Reserve Economic Data in the US) on the next
page shows the spread between the 2-year and 10-year US government bonds for
the last 10 years.

You can see the spread dipped below 0% in the fall of 2019. Sure enough, a
recession did occur when Covid-19 spread across the world in early 2020. (The
grey shaded bar shows when the US economy was in recession.) The spread
briefly fell below 0% again late last month.

However, most of those reading these headlines and looking at the chart above
may not realize that this does not give us a complete picture of the actual yield
curve.

This is what I wrote on pages 186 and 187 of our book, Mind, Money &
Markets. “In 1996, Federal Reserve Bank economists Arturo Estrella and
Frederic S. Mishkin published a report in Current Issues in Economics and
Finance, entitled, ‘The Yield Curve as a Predictor of U.S. Recessions.’ Out of
twenty-six indicators that were examined, they discovered that the basic yield
curve was the best indicator to use for predicting a recession. They wrote, ‘The
yield curve – specifically the spread between interest rates on the ten-year
Treasury note and the three-month Treasury Bill – is a valuable forecasting tool.
It is simple to use and it significantly outperforms other financial and
macroeconomic indicators in predicting recessions two to six quarters ahead.’”

 

I hope you noticed that the authors used the interest rate spread on the tenyear
US bond and a three-month Treasury Bill, not the spread on the ten-year
bond and two-year bond. So, let us look to see what has happened to the spread
between the three-month or 90-day Treasury Bill and the ten-year bond last
month.

This chart shows that the yield on these two securities dropped below 0% in
the fall of 2019 just like the spread of the two-year and ten-year bond did.
However, if we look back at last month, when the yield curve inverted between
the 2-year and 10-year bonds, the spread on the three-month and ten-year bond
was close to 2%. That is not close to being inverted at all! If we look to the past,
recessions have occurred when the spread between the three-month Treasury Bill
and ten-year bond and the spread between the two-year and ten-year bond have
both inverted at the same time. The fact that the spread between the three-month
and ten-year bond was not even remotely close to being inverted last month
means there has not been a true or normal inversion of the yield curve in the
United States.

It is very unusual for the spread between the 2-year and 10-year yields to invert
while the spread for the 3-month and 10-year are so far apart. Perhaps there was a
trading anomaly with the 2-year bonds last month. Either way, history shows that
the spread between the three-month Treasury Bill and the ten-year bond is what
investors should be using to determine whether there will be a recession in the
next 12 to 18 months. The recent headlines might make some investors nervous.
However, for those who understand what we should really be looking at, the 3-
month and 10-year yield curve have given no indication that the risk of a U.S.
recession has increased.

 

SAR Update

My pager recently went off at 8:30 pm one night with the RCMP requesting
the help of my SAR team to assist a person whose snow bike would not start in a
valley near a local ski hill. A snow bike is a motorcycle where the front wheel has
been replaced by a ski and the rear wheel has been replaced by a track. They are
easier to maneuver because they are much lighter and narrower than a
snowmobile. Please see the photo from KTM below.

People like to ride them in between trees in places where snowmobiles cannot
go. It is easy for them to go downhill but sometimes they cannot make it back up.
In this case, the battery was dead and the newer motorcycles do not have kick
starts anymore.

Fortunately, the person had a GPS communicator that enabled him to call for
help and relay his exact location to us. I was what the Duty Officer that night,
which means I have to respond to the agency requesting our assistance to get more
information and then alert the team to meet and let them know what we need to
prepare for.

Our team does not have snowmobiles so I loaded one of my own snowmobiles
on my trailer and headed to the scene while my colleagues met at our base. There,
they loaded avalanche beacons, shovels and probes and hitched up the trailer with
a Honda Pioneer 1000 side by side ATV on it that has tracks on it instead of
wheels from November to April. It can carry five people and some gear. We
arrived at a mountain top fire station in the area at 10 pm. Four people went to the
top of the mountain in the ATV while I drove my snowmobile. Please see the
photo of our team preparing to head out on the ATV.The person requiring assistance was able to contact some friends, who had
snow bikes, to ask them to find him and help him provide a jump start for his
battery. Thank goodness it was a nice evening with moonlight, decent visibility
and excellent snow conditions. My colleagues and I observed the movements of
the snow bike lights in the valley below from the mountaintop while my other
colleagues remained at the command center. All parties on the snow bikes made it
to our location on the mountaintop at 1 am with everyone in good condition.

Some people like to sit in a bar and visit with friends until 1 or 2 am in the
morning. I much rather prefer to be involved in situations like this with my
colleagues. It is nice to get a rush of adrenaline every once in while too. By the
time we loaded up our equipment and drove home, I slipped into bed at 2:30 am
with another successful task completed. It was an enjoyable experience with great
men and women with an excellent outcome. Happy Easter my friend!

My favourite verse in the Bible comes from Easter time. A criminal was crucified
on each side of Jesus as punishment for their crimes. One criminal scoffed at
Jesus while the other said, “Jesus, remember me when you come into your
kingdom.” With that simple expression of faith Jesus responded with ultimate
grace by saying, “Truly I tell you, today you will be with me in paradise.” Luke
23:43. That, my friend, is what Easter is all about.
Photo from iStock