3 Reasons Interest Rates have Reversed and are Headed Down
The potential trade war seems to have become significantly more likely, post the recent round of Trump tweets on May 5th.
Trade talks that seemed close to an agreement suddenly went up in smoke. We believe that a trade war is now over a 50/50 probability. While logic would imply that China and the US find a reasonable solution to enforce fair trade practices, especially around intellectual property rights, logic does not always prevail in politically-driven or nationalistic situations. The negative impact on global trade has the potential to push the world into a recession.
Gridlock in Washington is spilling over into all policies whether or not they are mutually agreed upon.
For instance, both sides of the aisle agree that US infrastructure is in need of desperate repair and that investing in these areas would produce very high returns on invested capital. However, the gridlock in Washington is preventing any meaningful progress with regards to an infrastructure bill.
The Federal Reserve Board’s (the Fed) reversal on its stated interest rate policy and balance sheet management at the end of last year.
In the fall, the Fed had suggested that the balance sheet shrinkage was on autopilot and that interest rates would be moving significantly higher over the following year. The slowdown in the economy, coupled with a negative stock market reaction in the 4th quarter, forced the Fed to pause their interest rate hikes. This contributed to a rally in the long end of the Treasury market, which means bond prices went up and interest rates went down. The interest rate on the 10 year Treasury, as shown below, dropped from 3.24% on November 8th to 2.27% on May 28th—almost a full percentage point.
While interest rate moves are very complex, they are determined by investor supply and demand, which is determined by a combination of economic activity, inflation, Fed policy, and federal government spending, all of which are intertwined and change based on many variables. It makes predicting interest rate turns and moves nearly impossible. However, over long periods of time, the 10 year Treasury has generally been near the rate of change to nominal GDP (real GDP plus inflation) which is currently running at around 5%. This suggests that over time the 10 year Treasury rate will be moving up, but predicting the timeframe of this move is not possible as too many interrelated variables with reflexivity are present. Nonetheless, the question becomes “How do investors position their portfolio given the very low return streams coming off of fixed income investments and the possibility that fixed income prices will come down as interest rates go up over the next several years?” We suggest the use of diversifying assets like real estate, reinsurance, infrastructure, timberland and alternative lending as a way to provide income off a portfolio while providing diversification benefits. Please see the link here for a free chapter of Wiser Investing which explains how diversification works.
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