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Keep An Eye On Interest Rates

 The US 10-year Treasury yield is climbing.

On Monday, it reached 2.99%. At time of writing it is a bit lower, about 2.97%. If you are not familiar with bonds, they are basically a loan, from one party to another.

Governments and corporations issue bonds to raise funds. Through bonds, an investor can lend them money for a period of time. The investor then gets repaid their original amount of money plus interest.

So, what’s the big deal about bond yields rising?

Well, higher bond yields can mean higher economic growth. They could also be signaling higher inflation. And higher inflation could mean higher interest rates in the future.

After the 2008 crisis, the world’s three main central banks embarked on a program of quantitative easing (QE) to jump-start the economy. They lowered interest rates and increased the money supply.

Years of low interest rates and cheap money have pushed up asset prices and have increased debt around the world.

How much debt?

Well, here is a chart editor Vern Gowdie from The Gowdie Letter shared with us last week.

Source: ERC/Paradox of Prosperity
[Click to enlarge]

Global debt has almost doubled

As you can see, global debt has grown from US$87 trillion in 2000 to US$199 trillion in 2014. Corporate and government debt have almost doubled in that period.

Now, after eight years of monetary stimulus, central bankers are looking to reverse this trend with quantitative tightening (QT). That is, increasing interest rates and reducing the money supply.

The Bank of England raised rates last November for the first time in 10 years. The European Central Bank and the Bank of Japan are looking at ending asset purchases.

The US Federal Reserve is also tightening by pushing up interest rates and decreasing their balance sheet. If QE resulted in a free flow of credit and high asset prices, QT could bring about the opposite — asset prices tumbling and credit tightening.

What’s the need for QT?

Well, the Fed wants to bring interest rates up to what they consider ‘normal’ levels before the next crisis. If we hit a recession before they are ready, they fear they will have no tools to fight against it.

The Fed is expected to raise rates three times this year. Yet a return of inflation could mean they get spooked and tighten faster.

The Fed will try to get the balance just right. That is, at the point where the economy is maintaining employment and inflation on the target rate without overheating.

It is a balancing act. If they tighten too fast they risk triggering a recession.

At the same time, the US government is spending more money.

The US government has passed a big tax break and has an infrastructure plan coming. These are both inflationary policies.

Interest rate hikes can hinder the stock market

Higher inflation and interest rates could also mean higher bond yields.

As we have seen, bond yields are already rising.

Which means that investors are expecting more interest rate hikes and higher inflation. This could also mean that money starts flowing out of stocks and into fixed income.

You see, when interest rates rise, bond prices fall.

A reason share prices have kept rising is because companies have offered better returns than fixed income assets like bonds. But rising interest rates will make borrowing more expensive for companies. This can lower their earnings.

With the US stock market looking overpriced, this could make shares less attractive.

As Bloomberg reports:

Since the financial crisis, stocks have paid out more than fixed income, but the premium is waning: The spread between the S&P 500’s earnings yield and that of the 10-year Treasury bill is hovering near the lowest levels in eight years.

‘If yields push past 3 percent, that could alter the value proposition for equities versus fixed income for years to come, according to Chris Verrone, the head of technical analysis at Strategas Research Partners.

Source: Bloomberg
[Click to enlarge]

If bond yields start rising, we could see investors start flowing out of equities and into bonds.

But the biggest worry is that higher bond yields could be signalling higher inflation and that higher interest rates are coming.

This is quite a risk in a world that is highly in debt. According to the International Monetary Fund, the world has just reached a record high of US$164 trillion.

Debt has not only been increasing in the corporate and government sectors, but all areas of the economy that have taken advantage of cheap money.

So far, this large debt has been manageable because of low interest rates. While debt has gone up, interest rates have remained constant.

Yet if interest rates go up, this debt could become a burden.

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