Risk of Higher Interest Rates

With another strong labor report (unemployment down to 5%) the Fed is probably going to raise interest rates next month. CNBC reports that US bonds fall in expectation of a rate hike.

U.S. sovereign bonds declined on Monday, following European and Asian bonds lower as global markets prepare for a hike in interest rates by the U.S. Federal Reserve next month.

Yields on benchmark 10-year Treasury notes rose to 2.3576 percent on Monday, up from 2.333 percent. Bond prices and yields move inversely.
Thirty-year Treasury bonds yielded 3.1229 percent, up from 3.090 percent.

The bond market expects higher rates and lower valuation of bonds currently held but the risk of higher interest rates is more widely spread and includes U.S. stocks.

U.S. Stocks

The recent mini rally has put the U.S. stock market back on track, right? Maybe that is not the case. Companies with investment grade credit rating are being bid up and those with worse credit and seen as at risk are in decline. Bloomberg Business writes about warnings found in investment-grade credits.

Across the Standard & Poor’s 500 Index, evidence has surfaced that the stresses that blew into credit markets this summer have changed the way Americans view stocks. Case in point: for one of the few times since 1996, companies whose bonds are rated investment grade are trading with higher price-earnings ratios than those rated junk.

Concern about credit quality provided the prologue to the stock market’s 11 percent decline in August and, unlike the swoon itself, it hasn’t gone away. The flip-flop in valuations highlights newfound caution among investors who for most of the past two decades paid more for junk-rated companies, convinced they’d grow faster while falling rates kept solvency concerns at bay.

The point is that the cost of doing business (borrowing) is about to go up for companies that can least afford it. The expectation that stocks with speculative credit ratings will outperform blue chips seems to be going away as blue chips are being bid up in expectation of higher interest rates. The consensus on investors to flee to quality and dump junk is a measure of the risk of higher interest rates. So when will this happen and how high will rates go?

U.S. Federal Reserve

The U.S. job market turned in a great month which means the Fed is likely to raise interest rates according to The Washington Post.

“The economy’s course is steady and true,” said Chris Rupkey, chief financial economist at MUFG Union Bank. “The reasons for Fed caution and delay are falling to the wayside as this economic expansion is the real deal.”

The probability that the central bank will move at its next meeting in December jumped to nearly 75 percent on Friday, according to futures markets, up from roughly even odds a week ago. Barclays reined in its forecast from March 2016 to December. Famed investor Bill Gross of Janus Capital was unequivocal, telling Bloomberg TV he believes the chances are “almost 100 percent that the yellow light changes in December to bright green.”

Watch the rate of inflation if you want to know how fast and how high interest rates will be raised. The Fed is charged with maintaining price stability and optimal employment. Interest rates that are too high and go up too fast may stifle inflation but will also put people out of work. Not raising rates will allow inflation to creep into the picture, especially as the world economy heals and energy prices go up. Meanwhile the risk of higher interest rates is that weak stocks will suffer, the bonds in your portfolio will devalue as rates go up and mortgage interest rates on your new home will rise as well.

The flip side of the risks of higher interest rates is when you are looking at negative bond yields. In this case, you buy bonds to preserve some capital instead of risking everything in a market crash.

Risk of Higher Interest Rates PPT

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