It Better Be A Taper Tantrum
In 2013, the Fed announced they would reduce stimulus by lowering the amount of bond purchases in the future. Naturally, the bond market threw a fit.
Long term yields rose, the Fed capitulated and resumed purchases.
Stocks didn't care because the economic growth was accelerating.
In 1994 and 2013, stocks didn't care about rate increases.
In 1972 and 2000 stocks cared a lot about the rate increases.
Long term interest rates are on the move. While the central banks focus on moving short-term rates, the market calibrates growth, inflation, supply and demand to determine long-term interest rates. If inflation is rising and a deluge of government bonds is hitting the market, prices will weaken and yields will go up. Today we see both of these concerns as the economy accelerates out of the pandemic recession and Congress debates a $1.9 trillion stimulus program funded with debt.
Figure 1 - 10 year bond yields for the US, Australia, Germany and Japan
The 2013 Scenario
In 2013, the Fed announced they would begin slowing their stimulus policy by lowering their purchase of US Treasury bonds. This period is affectionately called “The Taper Tantrum” where the bond market fell and interest rates rose. Stocks did not care because the economy was expanding and the interest rate increase was not thought to be a threat to growth. The Fed hopes this is the situation we face in 2021.
Figure 2 - The Taper Tantrum Of 2013
The 1994 Scenario
There is some justification for the view that short-term pops in interest rates are not fatal for the stock market. A situation similar to 2013 occurred in 1994.
Figure 3 - The Rate Increase Of 1994
Rising Interest Rates Create Problems
Every post-war recession in the United States has been associated with a rise in short-term or long-term interest rates. At this point, it is not clear if the current rise in rates is enough to worry about, but the big unknown is the impact on our growing pile of debt. Both the public sector and private sector have added substantially to their debt burdens in the last 20 years. Higher debt loads mean that when rates rise, interest expense rises significantly.
Figure 4 - Interest Rate Changes And Recessions
Figure 5 - Rising Debt Levels Last 30 Years
Two Scenarios Nobody Wants To See
Here are 2 charts every bond and equity analyst on Wall Street is looking at right now. The first shows us a mid-point in the dramatic rise of inflation during the 1960s and 1970s. In this particular case, we had a confluence of several events that made the impact of the interest rate increase and subsequent recession/bear market very painful:
1. President Nixon took the dollar off the gold standard.
2. OPEC started their first oil embargo.
3. Bank regulatory changes made it easier for banks to lend.
Figure 6 - The 1972 Scenario
The second chart shows a period most of us remember; a time of rising interest rates, mild economic deterioration, extraordinary high valuations, a "new" trading paradigm, and a confident Fed. In 1998, the Fed added stimulus after the Asian currency crisis and over fears of Year-2000 (Y2K) computer problems. After 2000, they began to reduce stimulus. The year 2000 is not a perfect analog to 2021, but is worth looking at.
Figure 7 - The 2000 Scenario
Debt-to-GDP Ratio As Proxy For Indebtedness
There was one off-setting factor not widely discussed in the 1972 scenario. After World War II, broad debt levels remained constant as the US economy grew in the 1950s and 1960s, resulting in a fall in the critical debt-to-GDP ratio. This meant the 1970s rise in interest rates was less painful for the broad economy because overall debt levels were low compared to the size of the economy. Today, that situation is reversed and we are carrying record levels of debt as a society. It is unclear what changes in interest rates mean for the economy, but it is safe to say we are more sensitive to changes than in 1970 or 2000.
Figure 8 - Federal Debt-to-GDP Ratio 1940-2020
The markets are turning their focus to interest rates and away from pandemic problems. It is too early to say if the recent rise in interest rates is enough to derail the economic recovery and equity bull market. They key factors to watch will be the bond market's willingness to accept large Federal debt sales and the Federal Reserve's ability to suppress interest rates. The bond market is like a long running poker game, with the stakes rising the longer the game continues.
Robert Lloyds, CFA®
Chief Investment Officer
Lloyds Intrepid Wealth Management
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