Rising Interest Rates Are a Serious Concern

The recent jump in the 10-year treasury rate is concerning for several reasons. First, it is an indication that demand for U.S. debt is weakening. This makes sense because we keep selling trillions of dollars of new, additional debt to fund the massive, repeated rounds of stimulus. Since the U.S. government does not have the money to fund the stimulus, they have to sell bonds to raise that money. The national debt is at crisis levels. It was already at crisis levels before Covid-19, and now it is its own pandemic. We cannot simply look at the U.S. debt in a vacuum. We depend on other countries and people and institutions in those countries to buy our debt. If they decide they will no longer take the risk of buying our debt, we will not be able to service our debt, and we will default. At the least, if demand continues to weaken, we will be forced to offer increasing interest rates on our debt to entice investors to purchase our bonds.

The second issue, which Powell discussed today, is inflation. Rates will go up one way or another, either because investors sell bonds because they know rates will increase, or because the Fed begins raising rates to combat inflation, or some combination of the two. Rising rates will help slow inflation, but the cost is more expensive borrowing, which translates to less economic activity. It will be very difficult for the Fed to control the rise in rates, balancing on the one hand curtailing inflation, and on the other, avoiding a recession.

A third negative consequence of rising rates in the impact this will have on real estate. I have seen many studies on the real estate market, and there doesn’t seem to be a direct correlation between rising interest rates and falling real estate prices. However, mortgage rates a priced off of the 10-year treasury rate. One of the key drivers of the boom we have had in real estate since the financial crisis has been historically low mortgage rates. If that driver goes away – if mortgage rates are no longer historically low – it stands to reason that the real estate market will, at minimum, cool off a bit, and possibly could go into a prolonged decline.

Many investors today have never known anything other than a bull market for stocks, real estate, bonds, precious metals, cryptocurrencies, art, collectibles, and virtually every other asset class. It will be interesting to see how this new generation of investors deals with adversity, should these various markets weaken due to rising interest rates.

Current Conditions Warrant Caution

There are a host of reasons to be cautious at present. Government spending, supported by an avalanche of debt, has propped-up the stock market and the economy, but it cannot continue. As with all borrowings, there must be a lender to provide the loan. After several trillions of dollars of new treasuries issued, one must question who is going to continue to buy new bonds the federal government tries to sell? Following this same reasoning, who is going to continue to buy the debt of the individual state governments?

If we examine the real estate market, it too is supported in large part by debt – buyers borrow from banks to secure mortgages to buy properties. We all remember what can happen to the real estate market when too much debt is accumulated (do you remember 2008?).

If we look at virtually any asset class – stocks, real estate, bonds, art, precious metals, and even cryptocurrencies – all are at or near all-time high prices. Again, we must ask – how can this be sustained?

For markets to continue to move higher from current levels, new money must enter the market. Where will that new money come from? The economy, despite the federal and state governments’ best efforts through borrowing to provide stimulus, there simply is not enough money available to support continued growth for the economy; it’s just too large. Those unemployed receiving unemployment benefits, at some point, will stop receiving those benefits. When that happens, unless they have found jobs, they will no longer be able to pay their bills, spend to support the economy, pay for their mortgages, etc. They certainly will not be purchasing stocks or real estate.

It appears that the current argument for continued growth is that, with the vaccine for the Coronavirus now being distributed widely, that the economy will recover. This is an overly optimistic viewpoint for several reasons. First, even if everyone gets vaccinated, and even if the vaccine is 100% effective against the current strains and any future strains, so that the virus is no longer a detriment to economic growth, thousands and thousands of businesses has failed. Those businesses will never reopen, regardless of any success we have with the vaccine. Second, if we follow the logical progression from the failed businesses, millions of people lost their jobs when these businesses failed (there are at least 14 million people unemployed as a result of Coronavirus right now, and that number grows every week). Without those businesses, there are no jobs available for these unemployed workers, regardless of the vaccine’s effectiveness.

The most important consideration is that there are serious, fundamental challenges to the economy that have been created by the massive borrowing of the federal and state governments. Inflation is a very real probability. Taxes, both at the state level, and at the federal level, will increase (Biden has already stated that he plans to raise taxes). Interest rates have already started creeping up in anticipation of the Fed raising rates to combat inflation. Higher taxes and higher interest rates will reduce borrowing, and will cause refinancing existing debt to be increasingly expensive. All of this – higher taxes and higher costs for debt, will pull money out of the economy, reducing GDP growth, which will likely push the U.S. economy into recession or possibly a depression, depending of the pace of the increases in taxes and interest rates.

With all of this in mind, I recommend caution. Holding significant cash balances is a prudent strategy at this point. Continuing to purchase stocks at ever increasing all-time highs is foolish, and frankly dangerous, especially for those planning to retire within the coming ten years. Keep in mind that the vast majority (almost all) money managers, mutual fund managers, hedge fund managers, and the like, have a mandate to remain 100% invested regardless of how high stock and bond prices may go. This means that the decision to raise cash falls on the investor. In other words, investors cannot depend on their financial advisor, investment or mutual fund manager, to raise cash. It is up to you!