Interest Rates, Friend or Foe?

In our last post concerning interest rates, we included a graph and commented on the sudden movement of the 10 year treasury.

Due to the many questions from our post and from the attention the genearal media has been giving the subject, we felt it worth visiting again.

Why are we concerned about interest rates?

Since 1980 interest rates have been falling and this creates a tailwind for many investors in areas such as:

  • Residential Home Prices (Lower rates generally make residential homes more affordable putting upward pressure on prices)
  • Commercial Properties (Lower Cap Rates, direct correlation to interest rates, increases values and increases cash flow)
  • Stock Prices (As a general rule, lower rates leads to higher PE values, which generally leads to higher stock prices)
  • Pension Benefit Lump Sums (Lower rates leads to much higher lump sum benefits for pension beneficiaries and much higher cash contributions for employers..more on this in our next Newsletter)
  • Lower Inflation Expectations (Generally companies will not hord inventory in a declining inflation period in effect popularizing short lead time processing,  leading to more cash in the bank)

Twenty nine years is a long time, and many of us have forgotten the effects of a lower interest rate tail wind, and is some cases not only forgotten, but come to expect long term rates to slowly fall.

It will be hard for rates to fall much more !

At the end of 2008, the 10 year treasury yield touched the low 2%, yes that is right 2%! Taking a quick look at the chart at the end of our post you will notice rates in early 1980 were in the mid 15% range.

If rates climb excessively, all of the bullets we mention above turn negative for investors and rates become a headwind.  So what is excessively, somewhere between 6% and 10% will be excessive! Rates, just as capital markets do, will most likely overshoot and go too high before finding their footing. As of today’s post the 10 year treasury is yielding 3.889%

We will be watching rates closely as well as policy makers to see what their stance is on rates, but again as we have mentioned, now is most likely not the time to be purchasing long term fixed income instruments. JK

 10 Year treasury 1962-2009

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