Interest Rates Tell the Story
The wild pace of change coming from Washington is disorienting to say the least. Should we be worried or encouraged, terrified or elated? With so much being said and written it can be quite hard to know what to believe and what to make of it all. Much of the current reporting is quite good: especially print editions of the Wall Street Journal and New York Times, and there are several thoughtful podcasts. Coverage from cable news programs, popular influencers, social media, etc. seems much less helpful. Is there a concise metric that provides a reliable indicator? I think so. And it sends warning of potential risks ahead: not necessarily crisis, but not smooth sailing. In my view, the signal says beware of potentially rough seas as we move forward.
The Stock Market versus the Bond Market
Stocks aren’t the signal I speak of. The stock market has been described as a massive information processor that can provide valuable insights, especially over the long term. Eventually stocks tend to follow corporate earnings, but in the very short term they can be volatile and neurotic, prone to overreaction and the occasional bubble. Signals sent by the stock market can be misleading, especially in the short term. This can lead to problematic decisions. As Keynes famously quipped “The market can stay irrational longer than you can stay solvent.”
The bond markets is different. While stock investors imagine an expansive future, bond investors worry whether issuers will be able to repay what they owe. Stock investors see bright times to come. Bond investors fear it might all come to ruin. Stock investors come in many types: big and small, sophisticated and adolescent, institutions with massive resources and bros on their phones. Only professional institutions invest in bonds in any significant way. Bond investors are a famously sober, cautious, even cynical lot.
As a result, signals sent by the bond market are considered very dependable and deserve careful attention. The primary signal sent by bonds: interest rates (at different points along the “yield curve”). What are rates saying right now? As of this writing, rates are elevated but not extreme. The 10-year Treasury is in the high fours.
Aren’t Rates Set by the Fed?
Short term rates are set by the Fed but longer term rates, such as the 10-year Treasury, are set by markets. No one controls long term rates. Bond investors buy or sell large quantities of bonds according to what they think is going to happen in the economy. For example, if they think there is a risk of recession or higher inflation, they may sell their 10-year Treasuries and move to relatively safer investments such as short term Treasuries, T Bills, or cash. If enough institutional investors make this adjustment, they could drive down the price of the bonds they’re selling, which drives up the yield (aka, interest rates).
Why Does this Matter?
Today’s higher interest rates could indicate that large numbers of skeptical bond investors have worries about the potential performance of the US economy. The “yield” on the 10-year Treasury is super important also in that it is the benchmark used to set rates throughout the economy such as rates on mortgages, car loans, credit cards, corporate bonds, and so on. Rising rates can in turn become a drag on the economy as borrowing costs more. While there is some debate about the degree to which higher interest rates impact the modern US economy, the fact that rates are not coming down quickly for the past year could be a worrisome signal about future economic health.
What’s the New Administration’s Plan for High Rates?
In a February 6th Bloomberg interview, Treasury chief Scott Bessent said: “With the president’s policies of energy dominance, deregulation and non-inflationary growth, I think that the 10-year is going to naturally come down.” Bessent is considered by industry insiders to be a serious and qualified appointment. What to make of his statement?
Energy dominance. It is debatable whether “energy dominance” could ease inflation pressures to in turn ease interest rates. The US is already very energy dominant. “The United States produced more crude oil than any nation at any time, according to our International Energy Statistics, for the past six years in a row.[1]” According to the USEIA (US Energy Information Administration), the US produces more oil than it uses. Oil prices are relatively low and oil producers may not want prices to go much lower and pose a risk to earnings.
Deregulation. Results may justify the means so long as you credibly end up with good results. The theoretical ideal is that deregulation and streamlining would align agencies and sectors with efficient modern realities, which could be non-inflationary. Perhaps reform is overdue, but too much or poorly implemented deregulation and reorgs can cause harm through unintended negative consequences. For example, excessive deregulation and lack of transparency throughout the early 2000s may have been a central cause of the Great Financial Crisis of 2008-2009. If thoughtful reform could improve impact, massive wholesale bashing of entire agencies could introduce largescale risks. This would likely drive long term rates up, not down. Which will win out: streamlining and cost savings, or unforeseen risks?
Non-inflationary growth. To my eyes, using tools I learned in econ classes years ago, the policies of the current administration seem potentially inflationary. If the administration can thread the forest of needles before them and actually produce “non-inflationary growth” then huge kudos to them. Remember, we did have low inflation growth for several years under Obama. But those were years of recovery from the Great Financial Crisis when there was substantial slack in the economy and interest rates were very low all along the yield curve. Not so today. We are at historic highs in stocks and macroeconomic metrics look relatively tight (e.g., low unemployment).
What Might Work?
Fiscal responsibility might do the job. A balanced budget could potentially reduce interest rates in a meaningful way, but no administration since Bill Clinton’s in the 1990s has turned in a budget surplus. The “federal deficit” is the amount added to the “federal or national debt” each year, and this has been going up most every year for decades.
Do deficits even matter? Not yet. But if left unchecked, we could reach a point where payments on the national debt overwhelm other budget items. This would be a fiscal hole that could be our ultimate undoing and is something many (including myself) see as one of the biggest threats to long term US stability. So long as the US dollar remains the world’s reserve currency, the Treasury can print money to pay for our debts. But this is a situation that might not last forever.
The federal budget can be divided into three large categories: 1) Mandatory Spending (Social security, Medicare, Medicaid, other mandated programs) at ~ 73%; 2) Net Interest payment on outstanding government debt at ~ 4%; and 3) Discretionary Spending which includes everything else (defense/military, veteran’s benefits, education, agriculture, housing, transportation, and so on) at ~ 23%.
There are no easy choices when it comes to cutting the federal budget. Since it seems that the administration won’t or can’t reduce Mandatory programs, the focus is mostly on Discretionary items. To have an impact, they’d have to cut very deeply. This is where the DOGE program is wreaking havoc. It seems like such a violent process. I wish there was a less drastic way to do this. Throughout political cycles, we haven’t found a way to reduce or control the expansion in government spending. So now it appears they’re giving destruction a try. Might work, might not, and worth the cost?
Conclusion
In summary, I think interest rates currently tell a mixed story: troubling but not disastrous. While rates remain more elevated than the Fed might want, it seems they’re not yet at alarming levels. But if rates move substantially higher, it could be bad news for stocks. If this happens, investors may want to reallocate out of riskier assets and into less correlated asset classes. On the other hand, if long term rates go down it could be a very good sign.
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There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
[1] U.S. Energy Information Administration; March 11, 2024 article “United States produces more crude oil than any country, ever.”