Field of Play
Goldilocks debt market
There has been a great deal of angst over the last six months about the rise of interest rates. This has recently been accompanied by a worry about ‘higher for longer’, i.e., that rates will stay high for a long while before coming back down.
In this post I will explore this concern and offer my thought that ‘higher for longer’ will actually be ‘higher for ever’, a return to normal interest rates, and that this is really healthy for the economy and the stock market.
A reasonable level of interest rates
The economy and the stock market will do best over the long haul if inflation is under control and borrowers and lenders enjoy a reasonable level of interest rates.
Most everyone would agree with that. The question is where we stand today on getting to that promised land. My thesis is that we are more or less there now. We will see it if we stop dwelling on short term rates , look at longer rates and step back to get perspective.
Serious inflation and serious deflation can cause havoc in the economy. In the last 50 years we have seen a major super cycle of inflation beginning in about 1970 and a battle to avoid deflation from 2009 to about 2020.
In many ways deflation was the worst enemy, worse than inflation. Japan suffered from on and off deflation for 30 years. The problem with deflation is that lowering interest rates alone will not conquer it. That’s why the Federal Reserve is targeting 2% inflation. If inflation is at 2%, central banks can lower interest rates to stimulate the economy. If inflation is at 0%, effectively, rates can’t be lowered
Ten-year bonds give us perspective
I have borrowed the following chart from a recent Morgan Stanley report by Michael J. Mauboussin and Dan Callahan titled Total Shareholder Return. Exhibit 3 shows how much it costs U.S. companies to borrow for ten years. BBB is investment grade and over three-quarters of U.S. companies issuing bonds have this rating.
I’ve added three horizontal lines at roughly the 2.0% level, the 4% level and the 5.5% level. These very roughly show where we are at present: firstly, Treasury Note Real Yields; secondly, Inflation Expectations (ten-year); and, thirdly, BBB Credit Spreads.
The interest companies pay to borrow money by issuing a bond with a ten-year term is made up of three components: firstly, bond investors want a real return on their money; secondly, they want to get their money back in ten years without losing ground to inflation; and, thirdly, bond investors demand extra protection for the risk they may not be paid (BBB Credit Spread over so called risk-free ten-year government treasury bonds).
A 15-year perspective
Exhibit 3 shows how the Fed has struggled over the last 15 years to avoid outright deflation. Since 2011 risk-free ten-year U.S. Treasuries have paid almost no interest. This has killed the return for bond investors and distorted the world of finance. During this period inflation was too low and lenders did not enjoy a reasonable level of return. Ironically, it was bad for borrowers as it encouraged massive borrowing and over-leverage.
Today the Fed is in the driver’s seat. It has all the tools to tap on the brakes if inflation rekindles. It has the room to lower interest rates if inflation comes in below target.
A 50-year perspective
What I read into the right side of Exhibit 3 (2023), is that the combination of a Treasury Note Real Yield of roughly 2% today and Inflation Expectations of roughly 2% is the best and most benign it has been since the 1970’s when inflation caught fire.
Goldilocks debt market
Today, companies can borrow money by selling bonds with a yield of about 5.5%. That is a reasonable cost of debt. Investors can buy corporate bonds and need not be afraid of inflation. They will earn a reasonable real return.
This blog is all about investing in common stocks. The best environment for stocks over the long haul is a stable economy with inflation within the central bank’s target range and credit market conditions that allow companies to borrow at reasonable cost and bond investors to get a reasonable real return. There have been many economic and finance distortions (over-leverage) created over the last 20 years. These will have to be resolved. But essentially, from a credit and inflation point of view, things look pretty good for the economy and the stock market over the next ten years.
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