When Do Higher Interest Rates Become Harmful To The Stock Market?
On Friday, the jobs report came out and it was a strong report. The consensus was expecting 180,000 new jobs in January and the actual number released on Friday ended up being 200,000. So why did the markets drop? The answer: wage growth. The jobs report not only contains how many new employees were hired but it also includes the amount
On Friday, the jobs report came out and it was a strong report. The consensus was expecting 180,000 new jobs in January and the actual number released on Friday ended up being 200,000. So why did the markets drop? The answer: wage growth. The jobs report not only contains how many new employees were hired but it also includes the amount that wages for the current workforce either increased or decreased on a year over year basis. The report on Friday indicated that wages went up by 2.9% year over year. That is the strongest wage growth number since 2009.
Double Edged Sword
Wage growth is a double edged sword. On the positive side, when wages are going up, people have more money in their paychecks which allows them to spend more and consumer spending makes up 70% of our GDP in the United States. I'm actually surprised the market did not see this coming. The whole premise behind tax reform was "if we give U.S. corporations a tax break, they will use that money to hire more employees and increase wages." The big question people had with the tax reform was "would the trickle down of the dollars saved by the corporations eventually make it to the employees pockets?" Many corporations in January, as a result of tax reform, announced employee bonuses and increases to the minimum wage paid within their organizations. The wage growth number on Friday would seem to imply that this is happening. So again, I'm actually surprised that the market was not ready for this and while the market reacted negatively I see this more as a positive long term trend, instead of a negative one. If instead the U.S. corporations decided not to give the bonuses or increase wages for employees and just use the money from the tax reform savings to increase dividends or share buybacks, then you probably would have seen only a moderate increase in the wage growth number. But that also would imply that there would be no "trickle down" effect to the middle class.
The Downside
This all sounds really positive but what is the downside to wage growth? While wage growth is good for employees, it's bad for corporate earnings. If I was paying Employee A $50,000 in 2017 but now I'm paying them $55,000 per year in 2018, assuming the output of that employee did not change, the expenses to the company just went up by $5,000 per year. Now multiply that over thousands of employees. It's a simple fact that higher expenses without higher output equals lower profits.
Wage Growth = Inflation
There is another downside to wage growth. Wage growth is the single largest contributor to inflation. Inflation is what we use to measure the increase in the price of goods and services in the U.S.. Why are these two measurements so closely related? If your salary just increased by $300 per month, when you go to the grocery store to buy milk, you may not notice that the price of milk went up by $0.15 over last week because you are making more in your paycheck. That is inflation. The price of everything starts going up because, in general, consumers have more take home pay and it gives the sellers of goods and services more pricing power. Visa versa, when the economy is in a recession, people are losing their jobs, and wages are decreasing. If you sell cars and you decided to raise the price of the cars that you sell, that may cause the consumer to not buy from you and look for a lower priced alternative. Companies have less pricing power when the economy is contracting and you typically have "deflation" not inflation.
When Does Inflation Become Harmful?
Some inflation is good. It means the economy is doing well. A rapid increase in inflation is bad because it forces the Fed to use monetary policy to slow down the economy so it does not over heat. The Fed uses the Federal Funds Rate as their primary tool to keep inflation in check. When inflation starts heating up, the Fed will often raise the Fed Funds Rate to increase the cost of lending which in turn reduces the demand for lending. It’s like tapping the brakes in your car to make sure you do not accelerate too quickly and then go flying off the road.
If some inflation is good but too much inflation is bad, the question is at what point do higher interest rates really jeopardize economic growth? The chart below provides us with guidance as to what has happened in the past when interest rates were on the rise.
correlation between interest rates and stocks
The chart compares every 2 year period in the stock market versus the level of the 10-Year Treasury yield between 1963 – 2017. For example, one dot would represent the time period 1963 – 1964. Another dot would represent 1964 – 1965 and so on. If the dot is above the “0.0” line, that means that there was a “positive correlation” between stock prices going up and the interest rate on the 10-Year Treasury yield going up during that same time period. Worded another way, when the dot is above the line that means the stock market was going up while interest rates were also increasing. In general, the dots above the line are good, when they are below the line, that’s bad.
Right now the 10-Year Treasury Bond is at 2.85% which is the red line on the chart. What we can conclude from this is going all the way back to 1963, at this data point, there has never been a two year period where interest rates were rising and stock prices were falling. Could it be different this time? It could, but it’s a low probability if we use historical data as our guide. History would suggest that we do not run into trouble until the yield on the 10-Year Treasury Bond gets above 4%. Once the yield on our 10-Year Treasury Bond reaches that level and interest rates are rising, historically the correlation between rising interest rates and stock prices turns negative. Meaning interest rates are going up but stock prices are going down.
It makes sense. Even though interest rates are moving up right now, they are still at historically low levels. So lending is still “cheap” by historical standards which will continue to fuel growth in the economy.
A Gradual Rise In Interest Rates
Most fixed income managers that we speak with are expecting a gradual rise in interest rates throughout 2018. While we expect interest rates to move higher throughout the year due to an increase in wage growth as a result of a tighter labor market, in our opinion, it’s a stretch to make the case that the yield on the 10-year Treasury will be at 4% by the end of the year.
If the U.S. was the only country in the world, I would feel differently. Our economy is continuing to grow, wages are increasing, the labor markets are tight which requires companies to pay more for good employees, and all of these factors would warrant a dramatic increase in the rate of inflation. But we are not the only country in the world and the interest rate environment in the U.S. is impacted by global rates.
The chart below illustrates the yield on a 10 year government bonds for the U.S., Japan, Germany, UK, Italy, Spain, and total “Global Ex-U.S.”.
global interest rates
On December 31, 2017 the yield on a 10-Year Government Bond in the U.S. was 2.71%. The yield on a 10-Year government bond in Germany was only 0.46%. So, if you bought a 10-Year Government Bond from Germany, they are going to hand you back a measly 0.46% in interest each year for the next 10 years.
Why is this important? The argument can be made that while the changes in the Fed Funds Rate may have a meaningful impact on short-term rates, it may have less of an impact on intermediate to longer term interest rates. When the U.S. government needs more money to spend they conduct “treasury auctions”. The government announces that on a specified date that they are going to be selling “30 million worth of 10-year treasury bonds at a 2.8% rate”. As long as there is enough demand to sell all of the bonds at the 2.8% rate, the auction is a success. If there is not enough demand, then they may have to increase the interest rate from 2.8% to 3% to sell all $30 million worth of the bonds. While the U.S. 10-Year Treasury Bond only had a yield of 2.71%, it’s a lot higher than the other trusted government lenders around the world. As you can see in the chart above, the average 10-year government bond yield excluding the U.S. is 1.03%. This keeps the demand for U.S. debt high without the need to dramatically increase the interest rate on new government debt issuance to attract buyers of the debt.
As for the trend in global interest rates, you will see in the chart that from September 30, 2017 to December 31, 2017, global 10-year government bond yields ex-U.S. decreased from 1.05% to 1.03%. While we are in the monetary tightening cycle in the U.S., there is still monetary easing happening around the world as a whole which should prevent our 10-year treasury yields from spiking over the next 12 months.
Impact on Investment Portfolios
The media will continue to pounce on this story about “the risk of rising interest rates and inflation” throughout 2018 but it’s important to keep it in context. If tax reform works the way that it’s supposed to, wage growth should continue but we may not see the positive impact of increased consumer spending due to the wage growth until corporate earnings are released for the first and second quarter of 2018. We just have to wait to see how the strength of consumer spending nets out against the pressure on corporate earnings from higher wages.
However, investors should be looking at the fixed income portion of their portfolio to make sure there is the right mix of bonds if inflation is expected to rise throughout the year. Bond duration and credit quality will play an important role in your fixed income portfolio in 2018.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
What is a Bond?
A bond is a form of debt in which an investor serves as the lender. Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank. The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or
What is a Bond?
A bond is a form of debt in which an investor serves as the lender. Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank. The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or paying off other debt.
How do Investors Make Money on a Bond?
Your typical bonds will generate income for investors in one of two ways: periodic interest payments or purchasing the bond at a discount. There are also bonds where a combination of the two are applicable but we will explain each separately.
Interest Payments
There are interest rates associated with the bonds and interest payments are made periodically to the investor (i.e. semi-annual). When the bonds are issued, a promise to pay the interest over the life of the bond as well as the principal when the bond becomes due is made to the investor. For example, a $10,000 bond with a 5% interest rate would pay the investor $500 annually ($250 semi-annually). Typically tax would be due on the interest each year and when the bond comes due, the principal would be paid tax free as a return of cash basis.
Purchasing at a Discount
Another way to earn money on a bond would be to purchase the bond at a discount and at some time in the future get paid the face value of the bond. A simple example would be the purchase of a 10 year, $10,000 bond for a discounted price of $9,000. 10 years from the date of the purchase the investor would receive $10,000 (a $1,000 gain). Typically, the investor would be required to recognize $100 of income per year as “Original Issue Discount” (OID). At the end of the 10 year period, the gain will be recognized and the $10,000 would be paid but only $100, not $1,000, will have to be recognized as income in the final year.
Is There Risk in Bonds?
Investment grade bonds are often used to make a portfolio more conservative and less volatile. If an investor is less risk oriented or approaching retirement/in retirement they would be more likely to have a portfolio with a higher allocation to bonds than a young investor willing to take risk. This is due to the volatility in the stock market and impact a down market has on an account close to or in the distribution phase.
That being said, there are risks associated with bonds.
Interest Rate Risk – in an environment of rising interest rates, the value of a bond held by an investor will decline. If I purchased a 10 year bond two years ago with a 5% interest rate, that bond will lose value if an investor can purchase a bond with the same level of risk at a higher interest rate today. This will make the bond you hold less valuable and therefore will earn less if the bond is sold prior to maturity. If the bond is held to maturity it will earn the stated interest rate and will pay the investor face value but there is an opportunity cost with holding that bond if there are similar bonds available at higher interest rates.
Default Risk – most relevant with high risk bonds, default risk is the risk that the issuer will not be able to pay the face value of the bond. This is the same as someone defaulting on a loan. A bond held by an investor is only as good as the ability of the issuer to pay back the amount promised.
Call Risk – often times there are call features with a bond that will allow the issuer to pay off the bond earlier than the maturity date. In a declining interest rate environment, an issuer may issue new bonds at a lower interest rate and use the profits to pay off other outstanding bonds at higher interest rates. This would negatively impact the investor because if they were receiving 5% from a bond that gets called, they would likely use the proceeds to reinvest in a bond paying a lower rate or accept more risk to earn the same interest rate as the called bond.
Inflation Risk – a high inflation rate environment will negatively impact a bond because it is likely a time of rising interest rates and the purchasing power of the revenue earned on the bond will decline. For example, if an investor purchases a bond with a 3% interest rate but inflation is increasing at 5% the purchasing power of the return on that bond is eroded.
Below is a chart showing the risk spectrum of investing between asset classes and gives a visual on the different classes of bonds and their most susceptible risks.
2
Types of Bonds
Federal Government
Bonds issued by the federal government are backed by the full faith and credit of the U.S. Government and therefore are often referred to as “risk-free”. There are always risks associated with investing but in this case “risk-free” is referring to the idea that the U.S. Government is not likely to default on a bond and therefore the investor has a high likelihood of being paid the face value of the bond if held to maturity but like any investment there is risk.
There are a number of different federal bonds known as Treasuries and below we will touch on the more common:
Treasuries – Sold via auction in $1,000 increments. An investor will purchase the bond at a price below the face value and be paid the face value when the bond matures. You can bid on these bonds directly through www.treasurydirect.gov, or you can purchase the bonds through a broker or bank.
Treasury Bills – Short term investments sold in $1,000 increments. T-Bills are purchased at a discount with the promise to be paid the face value at maturity. These bonds have a period of less than a year and therefore, in a normal market environment, rates will be less than those of longer term bonds.
Treasury Notes – Sold in $1,000 increments and have terms of 2, 5, and 10 years. Treasury notes are often purchased at a discount and pay interest semi-annually. The 10 year Treasury note is most often used to discuss the U.S. government bond market and analyze the markets take on longer term macroeconomic trends.
Treasury Bonds – Similar to Treasury Notes but have periods of 30 years.
Treasury Inflation-Protected Securities (TIPS) – Sold in 5, 10, and 20 year terms. Not only will TIPS pay periodic interest, the face value of the bond will also increase with inflation each year. The increase in face value will be taxable income each year even though the principal is not paid until maturity. Interest rates on TIPS are usually lower than bonds with like terms because of the inflation protection.
Savings Bonds – There are two types of savings bonds still being issued, Series EE and Series I. The biggest difference between the two is that Series EE bonds have a fixed interest rate while Series I bonds have a fixed interest rate as well as a variable interest rate component. Savings bonds are purchased at a discount and accrue interest monthly. Typically these bonds mature in 20 years but can be cashed early and the cash basis plus accrued interest at the time of sale will be paid to the investor.
Municipal Bonds (Munis) – Bonds issued by states, cities, and local governments to fund specific projects. These bonds are exempt from federal tax and depending on where you live and where the bond was issued they may be tax free at the state level as well. There are two categories of Munis: Government Obligation Bonds and Revenue Bonds. Government Obligation Bonds are secured by the full faith and credit of the issuer’s taxing power (property/income/other). These bonds must be approved by voters. Revenue Bonds are secured by the revenues derived from specific activities the bonds were used to finance. These can be revenues from activities such as tolls, parking garages, or sports arenas.
Agency Bonds – These bonds are issued by government sponsored enterprises such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac). Agency bonds are used to stimulate activity such as increasing home ownership or agriculture production. Although they are not backed by the full faith and credit of the U.S. Government, they are viewed as less risky than corporate bonds.
Corporate Bonds – These bonds are issued by companies and although viewed as more risky than government bonds, the level of risk depends on the company issuing the bond. Bonds issued by a company like GE or Cisco may be viewed by investors as less of a default risk than a start-up company or company that operates in a volatile industry. The level of risk with the bond is directly related to the interest rate of the bond. Generally, the riskier the bond the higher the interest rate.
About Rob……...
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.
Need to Know College Savings Strategies
Our newsletter this quarter is dedicated to helping families plan for what has become a life-altering cost of paying for college. But do not fear, there are simple things you can do to boost your children's college fund. It is not news to anyone that over the past 30 years, the cost of college tuition and room & board at all levels has spun out of control.
college savings strategies
Our newsletter this quarter is dedicated to helping families plan for what has become a life-altering cost of paying for college. But do not fear, there are simple things you can do to boost your children's college fund. It is not news to anyone that over the past 30 years, the cost of college tuition and room & board at all levels has spun out of control. The year over year increase in the cost of tuition and fees since 1978 to date has far outpaced any reasonable rate of inflation, and demands a new look at college savings strategies. In the chart below, you will see the increase in the price of college tuition and fee versus other comparable expenses over the past 30 years. Its mind blowing!!
The need for College Savings Strategies - US Inflation Image
Fund A 529 Account*
As far as college savings strategies go, there are very few options that beat 529 accounts as a savings vehicle for college. In these accounts you make after tax contribution to the account and when the amounts are withdrawn, as long as those withdrawals are attributed to a qualified college expenses, the earnings generated by the account are tax free. Depending on the state you live in you may be eligible to receive a state tax deduction for contribution up to specified dollar amount. In New York, single filers receive a NYS tax deduction up to $5,000 and married filing joint $10,000.
Also for financial aid purposes these account are looked at very favorably in the EFC (Expected Family Contribution) calculation. They are looked at by FASFA as an asset of the "parent" not the asset of the "child". There are many contribution and withdrawal strategies associated with these accounts that can produce big tax benefits for individuals accumulating savings for themselves or their children.
Roth IRAs Are Not Just For Retirement
When clients have the dual goal of saving for retirement and saving for college, the Roth IRA is often times a great option. Even if you make too much to contribute directly to a Roth, you can implement a "non-deductible IRA to Roth IRA conversion strategy" that will allow you to still get money into a Roth IRA.
Contributions to Roth IRAs are made with after tax dollars but unlike a traditional IRA if you hold a Roth IRA for at least 5 years and make withdrawals after age 59 1/2 you pay no tax on the earnings.
Here is one college savings strategy technique: You are allowed at any time and at any age to withdrawal the contribution portion of your account balance from a Roth IRA tax and penalty free. For example, if I contribute $5,000 to a Roth IRA and 5 years later it is worth $10,000, I can contact my IRA provider and request that they distribute just my basis ($5,000) and leave the earnings in the account to continue to accumulate tax free. You can then use that basis distribution to fund college expenses but the earnings in the Roth IRA continue to accumulate tax free.
Maximize Your Financial Aid
There are strategies that can be implemented leading up to the filing of the FASFA form that can increase that amount of financial aid that you receive. When you apply for financial aid, FASFA has a complex EFC calculation that takes a snapshot of your assets and income to determine how much financial aid you will qualify for. There are ways to shift assets and shelter income from this calculation that can save individuals and families thousands of dollars when it come to paying for college. Here are a few of the strategies that can help to improve a EFC calculation:
Save money in the parents or grandparents name, not the childs name
Pay off consumer debt, such as credit cards and auto loans
Spend down the students asset and income first
Accelerate necessary expenses (such as computer purchase) to reduce cash
Minimize capital gains
Maximize your contributions to a retirement plan
Do not withdrawal money from a retirement plan to pay for college
Ask grandparents to wait to give grandchildren money until after college
Trust funds are generally ineffective at sheltering money from EFC
Prepay your mortgage
Contribute to 529 plans owned by the parent or grandparent
Choose the date to submit the FASFA carefully
Michael Ruger
About Michael...
Hi, Im Michael Ruger. Im the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
