Renewed Investor Focus as Rates Jump
Suddenly, global equity and fixed income markets are focused on interest rate levels and potential inflation. On cue, volatility in treasuries and the stock market have returned. As reported recently in the Wall Street Journal: “A wave of selling during the past two weeks drove the yield on the benchmark 10-year Treasury note, which helps set borrowing costs on everything from corporate debt to mortgages, to above 1.5%, its highest level since the pandemic began and up from 0.7% in October.” While sudden increases in interest rates, such as the one experienced over the last few weeks, are not uncommon, they can be a potential warning sign of future inflation.
Sudden and prolonged increases in interest rates can negatively affect business and economic health. This is particularly true for businesses dependent upon debt financing. However, the potential danger is not limited to business.
Increased Rates Can Increase Consumer Costs
A sharp rise in interest rates can negatively affect consumers. Increased interest rates can result in higher consumer borrowing costs. Most notably in the form of higher mortgage payments and credit card interest. From a recent article in the Wall Street Journal: “The Fed’s rate cuts during the past year helped fuel a wave of home sales and refinancings, but the recent climb in yields drove mortgage rates to their highest level since November this past week, and applications have dropped.” Mortgage refinancings are a common way for homeowners to lower their monthly mortgage payments, as well as access equity in their homes. Higher interest and mortgage rates could take away this form of cost savings and access to cash for some homeowners.
However, it is important to note that both US government interest rates and consumer mortgage rates continue to remain near historical levels. The magnitude of the rate increase experienced in the last few weeks is not going to change that fact. In addition, a modest increase in rates is not likely to materially alter the supply demand dynamics currently at play in the residential real estate housing market.
Residential Housing Continues to Show Strength
In fact, today, residential real estate markets across the country continue to experience unprecedented demand and soaring prices. The residential housing market is still experiencing an historical shortage of new-construction homes for sale. The demand for new homes continues to be high and the supply of new-construction housing is at an historical low. This dynamic has led to higher home prices and surging demand from homebuyers. A change in consumer preferences away from large cities and toward suburban locations precipitated by the COVID19 crisis has only exacerbated this situation.
While the US 10-year Treasury Note yield has increased recently, many market participants believe that a modest increase in interest rates and inflation would be a positive signal. From the WSJ: “A series of Federal Reserve officials have said the climb is a healthy one, reflecting investors’ improving expectations for a vaccine- and stimulus-fueled economic recovery.”
Higher Rates Could Help Yield-Starved Investors
In some instances, higher interest rates could actually help income-seeking investors. For example, with a modest increase in rates, perhaps investors would not have to move as far out on the risk spectrum to earn yield.
As we have spoken about in the past, investors seeking income yield have had a challenging environment for some time now. Even investors in the high-yield corporate bond market are challenged to find income, with yields hovering near 4%. In this environment, there are not many viable options available for income seeking investors. Perhaps a modest increase in interest rates could help.
Steve Sapourn is co-founder and portfolio manager at Aloha Capital. He specializes in designing low-risk portfolios that reliably out-perform benchmarks. Steve has managed alternative investments in a variety of asset classes for nearly 25 years. His accomplishments include creating and implementing quantitative trading strategies in the futures, stock, and volatility markets. He’s also served as portfolio manager for a Fund of Funds, where he analyzed hundreds of alternative investment strategies.