By: Dividend Sensei
The market continues to vacillate between fearing rising interest rates, and not caring about them. For example, the current correction was triggered by a sudden surge in 10 year yields that came after the latest jobs report indicated wage growth had jumped from +2.5% YOY in November, to +2.9% in January. The market fear was that rising wages, courtesy of the strongest labor market in nearly 20 years, would cause inflation to start rising fast. As 10 year treasury yields (proxy for long-term interest rates) rose above 2.75% the market freaked out and plunged 10.1% off its all time highs set on January 26th, in just nine days. That’s one of the fastest correction starts ever.
However, in the past few weeks things seem to have settled down, as the market finally came to grips with the fact that a strong economy, rising wages, and the highest consumer, corporate, and small business confidence on record was actually a good thing. That seemed to evaporate yesterday, after the market got off to a strong day (up 1%) then suddenly did a U turn and fell to close at 0.5%. High-yield stocks like REITs and MLPs got whacked especially hard, with most falling 2% to 4% (some much more).
Once again the culprit was rising interest rates, with the 10 year yield spiking from 2.9% to 2.95% in a matter of minutes. However, the reason for this highlights just how twisted and irrational the market’s obsession with interest rates has become. What caused this sudden bond meltdown? The release of the Federal Reserve’s latest minutes (from their last meeting).
Specifically the Federal Open Market Committee or FOMC (who decides when and how much to raise interest rates) reiterated its view that the economy was strong, and it should continue its strategy of gradual rate hikes. That was it, no mention of accelerating the hikes (such as 4 increases in 2018 instead of the planned three), and no mention that its long-term Fed Fund rate target had changed from 3% (currently 1.25% to 1.5%). In other words, the bond market freaked out over nothing changing, at all. But here’s the even crazier part. The Federal Reserve has no direct control over the only rates that matter (to Wall Street), long-term treasuries.
The “rate hikes” that the Fed does are to what’s called the Federal Funds rate. It doesn’t directly control anything, other than the overnight, interbank lending rate. That’s the rate that banks use to lend each other overnight cash to ensure that each one can fund the various day to day cash movements that consumers and businesses make (such as credit cards, checks, etc). That’s not to say the Fed Funds rate isn’t important. If interbank overnight lending rates were all it controlled then no one would care.
Banks benchmark their Prime rates (rate at which they lend to their biggest and most credit worthy clients) off the Fed Funds rate. And consumer loans, for things like credit cards, personal loans, and lines of credit, are benchmarked off the Prime rate. So when the Fed raises rates 25 basis points banks usually respond (the next day) by raising their interest rates on customers.
This means that if the Fed overdoes it, say by raising rates every quarter for two years (a 2% total rate hike), then highly indebted consumers might face high enough rates to cause them to default on loans. That could potentially lead to higher bank losses, cut off consumer lending, and decrease consumer spending. And since about 70% of the US economy is driven by consumer spending this means that, theoretically, the Fed can cause a recession with rate hikes alone.