Market Violence & Interest Rates

Author: David R. Kotok, Post Date: February 5, 2018

Fierce forces at work on interest rates … or are we just seeing a mild adjustment? There is no way to know. We are referring to US Treasury interest rates on bills, notes, and bonds. Some bullets follow.

1. It is clear that the newly installed leadership of the Federal Reserve want to raise short-term rates to what they believe is “more normal.” That path seems to point to another 3/4 of 1% higher rates in shorter-term T-bills during 2018. The recent employment report guarantees this outcome.

2. The Fed’s strongest force is applied to short-term rates. Essentially, the Fed can put them at any level it chooses. What happens to markets and economic growth is a derivative of that Fed short-term rate policy decision.

3. The global impact of the short-term rate change can be profound. About $150 trillion in US dollar-denominated debt and notional derivatives is tied to this rate policy. Thus about half of the entire world financial system and debt structure undergoes a shift between lenders and borrowers as short-term rates change. Each single basis point (1/100th of 1%) equates to an annualized rate of transfer of $15 billion. That is the first-order effect. The second-order effects are found in the actions of market agents as each responds to the Fed’s policy change. Economic agents like businesses and households react, too, but do so with a greater time lag than financial markets.

4. The Fed is simultaneously engaged in QT (quantitative tightening). This is the shrinkage of the Fed’s asset holdings, and it translates into a different form of transfer. The Fed reduces its holdings of Treasury bills, notes, and bonds and federally backed mortgages. The market has no choice but to absorb them. QT is a directional force toward higher interest rates, and it will be an accelerating force if the Fed sticks to its presently stated path. We believe the Fed will not deviate from this QT path unless there is a market shock of some type. A single-digit percentage change in stock prices doesn’t qualify as a shock. Neither does a rise in yield to 3% on the 10-year benchmark Treasury note.

5. Coincidentally, the new tax bill and Trump administration deficit policy mean accelerating federal borrowing. Bigger deficits translate into larger Treasury auctions of bills, notes, and bonds. We already see that increased borrowing in an early stage, even though the Treasury’s debt management system is being messed up by Congress’s failure to pass budgets and workable debt limits. This political charade imposes a large cost on the US and its citizens, but that cost is not readily visible. Thus both houses of Congress get away with their behavior, and the public remains deceived and therefore ignorant of the cost.

6. Meanwhile the cost of rising deficits and restrictions on Treasury’s ability to manage the federal debt is expected to grow. This cost shows up indirectly in widening credit spreads, higher rates than would otherwise be, and changes in expectations as market agents adjust. We must add to that cost the impact on the federal budget as rising interest rates and increasing federal borrowing bring the US taxpayers’ interest cost from an annual level in the $400 billion range up toward $700–800 billion over the next few years. That trajectory is virtually assured.

7. Add into this mix a large foreign influence that originates in the eurozone. ECB President Mario Draghi is due to retire next year. He leans toward tapering up and away from negative rates and toward eventual normalcy. We don’t know what the new normal will look like in the eurozone or all of Europe.

8. What we do know is that eurozone low and negative rates have sucked US rates down. And we know that the sucking will now cease.

9. One final factor to consider is the interconnectedness of global finance. The old world is gone. In the new world, derivatives replace flows. We do foreign exchange swaps and forward contracts and settle the notional difference with a net payment between the counterparties. We do interest rate swaps the same way. We combine them into single instruments. We use these complex contracts in lieu of transferring actual payment. Only the net difference is transferred. This means FX and interest differentials show up first in derivatives. Expectations about them are captured there first. That is the new normal. Example: If you want to see how the market is pricing the expectations of changes in the dollar vs. the euro or the expectations regarding German–US interest rate differentials, look at the rate of change in the derivative for clues about tomorrow.

So where do these trends lead? Higher rates are already in play across the entire Treasury yield curve. Fed policy is likely to take them still higher over the next year.

In our bond portfolios we minimize holdings of Treasury paper. It is a bad deal. We favor well-selected credits with spreads to Treasury paper. And we manage duration risk actively with a barbell structure.

The fierce forces at work frighten many whose experience is limited to the last decade. This is new turf for Millennials. They will learn the hard way, just as they are receiving a lesson from Bitcoin.

We deployed some cash in the violence of the selloff. Some but not all was reinvested, as we will be scaling.

The vernal equinox brings volatility with it this year. That’s a good thing. It allows investment advisors to show what they’re made of.

David R. Kotok
Chairman and Chief Investment Officer
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