- Higher interest rates going through 2016 will have implications for most asset classes
- Past levels of Treasuries and how to play the move into new interest rate regime
- Assets that benefit from higher interest rates
Stock Markets might struggle
We can presume if job creation keeps staying above around 150k new jobs per month that the Fed will continue raising interest rates. That is the level the fed considers sufficient to cover new entries to the job market while actually adding jobs. This calculator allows you to see how many jobs are needed each month to maintain a given unemployment rate. The pace at which it hikes rates will depend heavily on job creation but also on how the stock market performs. The Fed, and Yellen in particular, do not want to be the ones that the public will blame for the next stock market crash.
A crash could happen if the Fed raises interest rates too quickly compared to the expansion of the economy. If the economy is not performing well enough it will be relatively more difficult for stock markets to gain higher ground. If interest rates move higher quickly enough, or rather the market has the perception that they are rising too fast, then we can certainly expect to see sharp declines in the broader stock market.
It might seem that the perfect play would be to sell S&P 500 futures and watch while the index falls. But what happens if it doesn’t? If the economy expands fast enough the broader stock market may not necessarily fall. Even if interest rates go up 1% over the course of 2016 we may still see a higher stock market by December. It makes more sense then to look at the Treasury yield curve and the expectations for next year.
Previous levels on Fed Fund rates and how to play the Treasury yield curve
Federal Reserve interest rates went up in the years leading up to the 2008 crisis. By July 2006 the Fed Fund rate was at 5.25%. The 10 year treasury yield remained between 4.50% and 5.25% for most of the following year. It started falling at the first signs of systematic break down in the Asset Backed Securities markets. This caused investors to exit those riskier assets for safer government bonds, therefore pushing down their yields.
10 year yields are around 2.40% as they are presumably already discounting further rises. But we are most likely to see Fed Fund interest rates rise much further especially if the economy holds on to its expansive phase. This means 10 year yields may also have much further to rise. In this scenario being short, or selling, 10 year treasuries may be a good hedge if rates rise further.
Looking at the 2 year treasury yield we see it’s currently around 1.04% but it was at the same levels as the 10 year yield back in 2006 and 2007. It would be reasonable to think it has even more room to increase as we move into 2016. Being short of 2 year treasuries may prove even more rewarding as it is even more likely to increase at a faster rate than the 10 year yield.
Another way to play into a higher interest rate regime is to put on a flattening curve trade. As we saw above the 2 year treasury yield is more likely to rise further and faster than the 10 year yield. So we want to sell 2 year treasuries. But we may be in danger of interest rates not going up or decreasing, to defend against that possibility we can buy 10 year treasuries.
Looking at the chart below we can see the small difference between 2 year and 10 year treasury yields when Fed Funds where at 5.25% between July 2006 and July 2007.
Source; US Dept. of the Treasury
The next chart shows how the difference between these two yields has acted over the past year. We can see that it is much greater with Fed Funds at much lower levels, 0.25% and now 0.50%, than it was when Fed Funds where at 5.25%. As interest rates go higher we should see the difference between these two yields shrink. That is to say the yield curve should flatten and the spread between the two yields diminish.
Source; US Dept. of the Treasury
Something to watch closely will be inflation; higher levels of inflation will make raising interest rates at a faster rate more likely. The Fed has a mandate to defend against crippling levels of inflation. This will lead therefore to higher interest rate levels and at a faster pace, if the economy continues to expand.
Assets that perform well with higher inflation
Inflation and higher interest rates are not a friend of stocks or bonds however they are a good friend to various commodities Gold in particular, but also other soft commodities which often make up elements of inflation baskets. Gold is seen as a safe haven against market stress and given the massive amounts certain countries are adding to their reserves it would seem that it continues to have a large attraction at all levels from investors and governments alike.
Private Equity is another type of security that may profit from higher interest rates, if the fund has the right type of investments. Certain types of infrastructure, like pay tolls, ports or utility companies often have their tariffs and fees linked to inflation. So a higher interest rate environment should lead to higher inflation and may benefit these types of operations. Not all Private Equity companies are private, there are a few that are listed on public exchanges.
Many are organized as Business Development Companies, and a bit like Mutual Funds, they have to pay out 90% of their profits in dividends to keep their tax benefits. There are around 200 publicly listed companies worldwide that invest in private equity. You can also find ETFs and Mutual Funds that invest in these assets. They also carry pretty much the same risk as other publicly traded stocks, in fact in the 2008 meltdown these stocks also performed badly as a class. But despite the high correlation to the broader stock market, a higher interest rate regime and consequently higher inflation, should favor these stocks over others.
