interest rate growth nixed.
Are high interest rates in our future? The Federal Reserve wants to keep short-term rates at near-zero for a long time. Only recently has the benchmark 10-year Treasury note nudged up, to 1.55%, from 0.5% last summer. What’s ahead? We asked the ever-wise Nicholas Atkeson and Andrew Houghton, principals at Delta Investment Management, in San Francisco, and they had quite a contrarian outlook:
Larry Light: How is the rate rise playing out in the capital markets?
Nicholas Atkeson: The popular market commentary today follows the logic that trillions of dollars of government stimulus will cause the economy to overheat, which will cause inflation to rise, which will drive interest rates higher and cause stocks to depreciate from multiple contraction. Contraction will be particularly powerful in high-multiple growth stocks. Year-to-date, the S&P 500 value index is up 6.9% versus the S&P 500 growth index which is down 1.8%.
When a certain market outlook becomes very, very popular, you may want to consider taking the other side. There are large, reputable bond trading firms that believe the recent run-up in the 10-year U.S. Treasury rate is closer to an end than the beginning and there is a possibility we will see new all-time low rates in 2022. If this contrarian perspective is correct, it is bullish for stocks in the intermediate term.
Light: Why would rates move lower?
Andrew Houghton: One argument for rates moving lower is: Technically, the 10-year Treasury rate has remained within a two standard deviation band since 1985. We have already moved one standard deviation and are approaching the high-end of the band.
But interest rates have historically hit trough lows several quarters following recessions. The sharp increase in yields year-to-date is inconsistent with the Fed’s dovish policy position and there is an expectation the Fed will push back against market repricing. Prospects are for asset purchases to extend into next year with short-term rates to remain pegged at zero until at least 2024.
Light: And how will that play out in the fixed-income market?
Atkeson: With a backdrop of benign inflation and easy money, investors will be tempted to reach for yield. There are few opportunities for fixed-income investors to boost current cash flow. Investors are likely to take on duration risk to obtain higher yields. Increased buying interest in longer-dated bonds will help keep yields down.
Light: What would the implications of rate decreases be for stocks?
Houghton: If interest rates were to subside from current levels, it may be a two-edged sword. On the positive side in the intermediate term, stock price/earnings multiples should stabilize and potentially expand further.
On the negative side, declining rates raises questions about economic growth and possible deflation, which are fundamentally negative for growth assets. That is, stocks. If all goes well, we may find a middle ground with more stable interest rates and appreciating stock values over time.
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