Posted by Steve Williams | October 17, 2018
Steve Williams is our investment analyst, he usually stays behind the scenes and we translate his guidance into plain English, except today - he has penned a guest blog for us.
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Around this time last year, I was nervous that there was a disconnect between the rate at which the Federal Reserve expected interest rates to rise and the rate of increase implied by equity and bond prices. The result was for a reasonably sharp but reasonably limited decrease in asset prices around the early part of this year.
The same set of conditions have prevailed in the last few weeks.
It is widely reported in the press that investors are reacting to a rise in he 10-year rate and to the threat of a trade war and just about anything else.
In my view, market movements are almost entirely owed to price changes connected with the potential for changes in short-term interest rates.
Consider the possibility of a 1.0 percent rise in the main policy rate of interest in the US – the US equivalent of our Bank Rate (or ‘base rate’) is the ‘Fed Funds rate’. Today, the upper limit on rates in the US is 2.25 percent. A month ago, bond prices implied that the probability of a Fed Funds rate at 3.25 percent by this time next year was just 11.5 percent. At that time the Federal Reserve thought there was a chance as high as 50.0 percent. That’s a big disconnect. And recent comments made by Jerome Powell, Chairman of the Federal Open Market Committee, have highlighted that disconnect. Jerome Powell thinks the US economy is doing very well and can happily sustain a gradual increase in interest rates. (I happen to think he’s right).
Last week, the yield on the 10-year treasury spiked higher from 3.0 percent to 3.25 percent – exactly as I would expect if the market was beginning to reappraise its assessment of future interest rates.
Indeed, the market implied-probability of a 1.0 rate rise by this time next year went from 11.5 percent to 20.1 percent.
And where the bond market went last week, the equity market has gone this week. It is no surprise that those stocks most sensitive to interest rates (low-yielding, highly-valued tech stocks for example) are those that have fared worst.
In my view, a rate rise in the order of 1.0 percent a year represents some kind of ‘not-too-fast, not-too-slow’ rate. And I think there is indeed a 50-50 chance that the Fed will increase rates by the full 1.0 percent over the next 12 months, beginning with a rate rise in December.
I’d feel much more comfortable if the market was priced for something like a 30.0 percent chance. So, a little more volatility – as prices further adjust – is entirely consistent with my outlook.
If I’m right in my assessment, the extent and duration of that volatility will be limited.
We might see some high-risk portfolios test a 10.0 percent decline in ‘peak-to-trough’ values. And it is not outside the bounds of possibility that some mid-risk portfolios do too, though I think this less likely.
Remember though, the reason the Fed want to raise rates is that the US economy is doing well enough to sustain rate rise. A strong US economy us good for the world economy. What is good for the world economy is good for investors.
In any case, the correct course of action is for long-term investors to stay focused on the long-term. I see nothing unusual in present-day market movements.
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