Mr. Toad’s Wild Ride is one of the few remaining original attractions at Disneyland Park. It is a wild adventure full of mayhem and havoc. Heading into this new era of economic policy feels like one of the ride’s hallmark hairpin turns. Unpredictable policy, deficit spending, and reduced foreign demand for treasuries are causing interest rates to increase. An increase in borrowing costs and a higher return on cash will prolong the rise in interest rates by slowing the economy and reducing income tax revenue. A quick tour of Mr. Trump’s Wild Ride leads me to the conclusion that interest rates are rising because of these five simple reasons.
Uncertainty in the markets takes the form of volatility, which has a negative correlation with asset prices. Given the inverse relationship between interest rates and price, an increase in volatility will coincide with an increase in interest rates.
Let’s say hypothetically that an increase in military spending will be offset by recuded healthcare expenditures. Still, the increased infrastructure spending will have to come from somewhere. This will likely be funded with debt. An increase in the supply of debt reduces the price, which leads to an increase in interest rates.
Reduced foreign demand for treasuries
We own most of our own debt through the social security trust fund and federal reserve, so renegotating US debt would not fix anything. Our largest international creditors, China and Japan, have other options. They will continue to reduce their demand for treasures as US credit worthiness deteriorates. Reduced demand leads to lower prices and higher interest rates.
Increased borrowing costs
As interest rates on government debt increase, so will interest rates on corporate bonds. Both residential and commercial mortgage rates will increase as well. Purchasing assets becomes more difficult as borrowing costs increase.
Higher returns on cash
As the period of near-zero interest rates comes to an end, the incentive to save money and earn high interest rates will return. While higher returns on cash may seem like a good thing, it comes at the cost of reduced investment.
Increased volatility, greater supply, and lower demand for treasuries are causing interest rates to increase. An increase in borrowing costs and a higher return on cash will perpetuate the rise in interest rates by slowing down economic growth and lowering income tax revenue. What is an investor to do?
The current economic outlook presents us with a conundrum. While banks may benefit from higher interest rates, weak economic growth will offset that to some degree. Whether or not the US actually defaults on its debt, we will certainly see panics and crashes over the next couple of years. Ratings agency downgrades, bank-runs, and capital controls combined with the factors outlined above will make it difficult for people to trust banks and take advantage of higher interest rates, while money under the mattress could lose value due to currency depreciation and associated inflationary pressures.
My personal reccomendation would be to purchase high quality stocks when market prices drop. This approach will provide you with a stable stream of growing dividend payments. You can subscribe to my newsletter Valunicorn for free during 2016 and remain grandfathered in for life! Whatever you decide, be prepared for a period of rising interest rates due to the five simple reasons outlined above.