• Post author:
  • Post category:Podcasts
  • Reading time:20 mins read

The Interest Rate Environment

Bond yields have jumped over the past couple weeks, jolting investors. The rise has triggered worries that faster economic growth could generate inflation and pose a threat at a time when the S&P 500 is at valuation levels not seen since the dotcom bubble.

Jeff Powell, CIO, Managing Partner & Founder of Polaris Wealth & Jeremy Witbeck, Partner at Polaris whether the level of rates is becoming a threat to investors and equity valuations.

Jeff Powell

Jeff Powell

Jeremy Witbeck

Jeremy Witbeck

Share on facebook
Share on twitter
Share on linkedin
Share on email

Jeremy Witbeck:
Welcome to our Polaris Podcast. I am Jeremy Witbeck, a partner at Polaris Wealth Advisory Group. And we have with us Jeff Powell. He is our managing partner and our chief investment officer. Jeff, good morning to you.

Jeff Powell:
All right. Good morning, Jeremy.

Jeremy Witbeck:
So, Jeff, we’ve had a lot of interesting comments with regard to some of the interest rate movement. Obviously, this is something that’s received a lot of coverage just in anticipation of it. And now that day’s finally here, where we saw meaningful changes in the 10, year, 20 year 30 year, interest rates that are being applied to different coupon instruments. And, Jeff, if you don’t mind, can you kind of summarize some of those shifts that have occurred? And then we can jump into what that means and why people are paying such close attention to this?

Jeff Powell:
Yeah, well, I mean, first of all, we’ll take a couple steps back when we’re talking about coupon instruments, what we’re really talking about is bonds. So if we’re going to be speaking English here, let’s what we’re talking about is having yields shifting. So when a bond is a bond is basically kind of like a mortgage, a basically, the US government is issuing it in this case, where they’re borrowing money in order for them to pay off our deficit is essentially what goes on within the Treasury. And because they are borrowing constantly, they have issued different length of time bonds for themselves. So if you can imagine buying your house and going out Well, I think some of it, I’m going to pay off real quickly. And some of it I’m going to put out further and I’m going to even have further payments. So they because they’re borrowing multiple times, have an option of where they’re putting out their their treasury bonds, and bills and notes. So so to speak. So I got a bond is a long term. A note is intermediate term I bill when you hear about it, is short term and nature with with its viewpoint, so bills are typically under a year. Bonds are typically 10 year plus and notes are typically between a one and a 10 year time period. So what we’re looking at right now, to your your statement is to have seen yields moving, the 10 year Treasury is one that’s looked at a lot. And the reason why it’s looked at a lot is oftentimes that’s being used for other debt instruments, like mortgages. And so when people are looking at what’s going on there, you know, if rates are going up, then I mean, some mortgages are gonna get more expensive. It also means that, you know, things are getting more expensive for the government, and so on, because that’s their borrowing rate. So as we see borrowing rates go up and down, it really kind of has an influence on the rest of the fixed income market.

Jeremy Witbeck:
So perfect suggests that you talked about some of the implications that that it has on things like mortgages and other instruments that are tied to that. Also, people will look at it and make inferences on equity investments. So things that historically aren’t bonds or aren’t bond, like why does it also influence those type of assets?

Jeff Powell:
That’s a great question. I mean, and one that most people probably would not connect well, because you weren’t talking. One is a equity, and one is a debt instrument. So why, why is it that a debt instrument would have that influence on an equity market, and here’s the long and short of it. So we got to, we got to set a little bit of of ground knowledge first before we can kind of get into the actual answer. So the one thing to keep in mind with bonds is, there is an inverted relationship between the price of the bond and the yield of the bond. Now, that’s a mouthful in and of itself, but just imagine kind of a seesaw, you got your fulcrum point in the middle. And on one side, you’ve got interest rates. On the other side, you’ve got price. So as price goes up, yields go down and value. So as we’re talking about this, the one thing to note is having the 10 year Treasury going up in yield means that prices have been coming down. So if you’re an investor in the 10 year, already, you’ve been losing money this year, being involved in your fixed income product or Now, why is there an inverted relationship? You know, Jeremy, you’ve heard me use this example, but I’m gonna use you in it instead of a guest when we’ve done speaking events, but imagine if I came to you and I said, Hey, Jeremy, I need $100,000 I need to borrow it from you. We’re in a zero interest rate environment. You know, maybe because it’s an individual and maybe because I need it for 10 years, you’re gonna charge me 5% above Fed Funds rates. The Fed Funds rates being at zero. Okay, I got a 5% loan. So I’m gonna pay you a $5,000 a year for 10 years. And in 10 years time, I’m going to give you your $100,000 back. I pay you in this case, semi annually. With which is what goes on with bonds. Imagine a Fed Funds rates rose, guess we got interest rates going up. Now. So yesterday or last week I signed, you know, the first contract with you, rates go up, miraculously 2%. overnight. Well, the going rate should be 7%, not 5%, if we’re talking about Fed Funds rates going up, so you should be getting 7000. Instead, you’re only getting five. And so if rates have gone up that quickly, the bond price will have gone down to offset that $2,000 differential, and the open market. So if you were gonna turn around and sell my debt to somebody else, you would have to take a discount or a loss in your bond in order to sell it in the open market. So that’s setting the ground rules. So your question was, Why does that matter? You know, what’s the implication? So, there’s more risk? Right, Jeremy? I mean, if you’re, if you gave me a one month loan, that’s a lot less risky than a 10 year, or 20, or 30 year loan, right? Sure.

Jeff Powell:
So when we’re looking even at the US government, you get compensated more for the duration of the bond that you have chosen. So the maturity date, so are you going to choose a 10 year loan, a 20 year loan, a 30 year loan, when you’re when you’re doing your house, you know, you’ve got a choice A 15, fixed a 10 year, a seven arm, you know, you got a lot of other options, the government does as well, and they’re gonna pay you less for the money that’s not away from your hands for longer. So typically, the the yield curve starts that I mean, if we’re looking at kind of bottom left to top right, it starts lower for the short term that where the shortest duration will be on the left side, all the way up to 30 year, where you’re going to be expected to be paying more. So when a yield curve flattens, or when it inverts, historically speaking, that is a precursor to a recession. And so in dealing with that, and the reason why that matters so much, is what ends up happening is that people start selling their short term fixed income. Now, why? Okay, so normally not in a right, zero interest rate environment, like we’ve got going on right now, because you can’t get lower than zero with the Fed Funds as at least, we have not gotten lower, we’ve got knock on negative like a lot of other countries have. But let’s just say for our purposes, zeros, the floor, you can’t go down further than that. But let’s say we’re back before, what went on with COVID, where we have rates sitting up to two and a half percent, the Federal Reserve is going to lower rates to combat a recession, that’s a form of stimulus you make lending cheaper. Okay, so if you’re making lending cheaper, you’re lowering rates in order to make it easier for people to borrow, and turn around and spend that money. So if we’re looking at that, a person who has short term, and even some of the intermediate term, they don’t want to take a pay cut, they don’t want their bond to mature. And then the next time they get a new bond, have it be 25 basis points, or 50 basis points lower than what it was. So they choose to sell it now. So when they start getting indications that a recession is looming, and it looks like the Federal Reserve, based upon probabilities, is going to start lowering rates, they sell their short term stuff, and they buy long term stuff. So if we have more sellers than buyers, what happens to the price Chairman,

Jeff Powell:
the price will go down.

Jeff Powell:
Exactly. You’ve got more people trying to sell something. So it’s a buyers market price goes down, yields go up. So your short term yields start going up, because you’ve got more selling pressure. So again, think about that, that seesaw, you got more selling pressure. So more price pressure down, yields are going up that’s going on in the short term side, and then they’re turning around and taking that money, and they’re buying an intermediate long term. So now you got buying pressure, more buyers and sellers, price is going to go up, yields are going to go down. And so that’s why, you know, when you’re looking at at a historical sense of what’s going on. That’s why the yield curve matters. We do have some strange stuff going on right now, though. And it is stuff that I think is worth talking about. In the fact that we’ve got over $15 trillion of negative yielding debt. If you look at Germany, be like a France, you look at Japan, on the short end of their yield curves, you’re not making money. So I mean, as much as I was willing to pay you 5% per year Jeremy for my 10 year loan. Imagine if I came to you and said okay, I’ve got the best investment for you in the world. Jeremy, you give me 100 grand and in 10 years time, I’m gonna give ivac, 90 to $7,000 guaranteed And oh, by the way, I’m not gonna be making payments at all during that 10 year time period. Are you game?

10:08
Sounds like a great investment to me.

Jeff Powell:
Exactly. So what? So what are you seeing happen? So you do have that person sitting in Germany, or sitting in Japan or sitting in France, and they’re saying the same thing, I’m not going to sit there and put 10 to 10 years worth of money to work, and have a guaranteed loss of 3%. So where are they buying? Right here in the good old US of A right. So what ends up happening is that buying pressure is also influencing our yield curve like never before. We’ve also seen the fact and this happened back in 2018, when the Fed was raising rates, people started to freak out that the Yoker was flattening, we felt like it was a complete. So 75% of time, flattened or inverted yield curve has happened before a recession. But that’s kind of a line by Statistics. Not all recessions have had that happen beforehand. And so what I was looking at within as you had the US government selling, I mean, right now, the US government has over $4 trillion of treasuries. So while all of this was going on, while our economy was strong back in 2018, and could absorb the Federal Reserve raising rates, they were just trying to normalize it, so that they could have one of their little levers to actually help stimulate the economy have ever needed. So they raised rates into a really strong economy. But then they also started selling treasuries. So again, $4.5 trillion, for the treasuries they had, they dumped over a half a billion dollars in a very short period of time, on a short term market. Again, if you’re throwing off that kind of money, or sellers and buyers, the price is going to go up. So we had a flattening yield curve, because you had foreigners buying our intermediate long term fixed incomes, because they were losing money there. And the US government trying to sell out from a treasury that that they had owned and wanted to, again, get off their books eventually. And you had kind of a perfect storm where people started reacting and saying, you know, recessions, coming recessions coming where it really wasn’t coming at all. So you can’t sit there and go, okay, yield curve is flattening, or normalizing and therefore, great things are coming on. Now, you really want to take it, it’s an aesthetic kind of statement, if, if the yield curve is flattened, or if it is inverted, then you got to look at why it’s happening. And if there’s not a economic Doom in the future, you really shouldn’t be running for the hills.

Jeremy Witbeck:
Jeff, that was a great explanation of why we look so closely at the yield curve. And just kind of summarize what you said, I mean, it can be a leading indicator as to market expectations as to what’s happening going forward. But to your point, it’s not like you can consider it in a vacuum, you have to look at the bigger picture and see, are there other explanations or other causes that may explain what’s happening here? And so the flattening or inversion of the yield curve, can signal recession, or the expectation of recession, probably more aptly said. But it can also signal the fact that to your point, negative interest rates outside the US meant it attracted a lot of buyers, which deflated yields. And that’s now that we have history on our side. And we can look back with 2020 vision. That’s exactly what happened. And to your point, I don’t know how well that was understood. That’s exactly what you explained at the time. So now that we can know that you call that one correctly, we’ll give you credit for that and say, it was a great read on what happened in the bond market. Going going forward. There’s also implications on equity markets, and one of the things that seemed tossed around is is this going to impact equities? Because it’s going to crowd out investment, meaning people are going to chase fixed income, because they can now get, say one and a half percent versus 1%. Just three months ago, can you talk a little bit to that what that looks like?

Jeff Powell:
Yeah. So I mean, what you’re talking about is we’ve had a big rise in rates on the the long end of the curve. So the 10 year Treasury has gone from 93 basis points at the first of the year. We’re sitting at breaking 1.4% today. So I mean, that is a big deal in some senses. I mean, really, what you’re talking about with regard to that is, you know, for a retiree that’s looking for income, you can go to the s&p 500 and buy stock and get on average 1% or, you know, 1.4 I think the issue is that, from a historical standpoint, these numbers are so low, that you really probably are not going to have much in the way of influence here. Because really, what you’re looking at is is 1.4 percent what most retirees can live off of? And I would say the answer is probably not. But you do have other things that are being influenced by that. One of the reasons why we are seeing the yield curve is a sense that there may be inflation in the future. We’re also saying that within the dollar, and so it’s one of the things that we keep on talking to our retirees about is that you’re not going to be able to retire the way that people have retirement days past. I mean, the dollar, you know, just even a year ago, was sitting and they 105108 range with the, with the euro.

Jeff Powell:
And now it’s sitting up in the 121 range. I mean, so that means that anything in Europe just got a little bit about 10% more expensive for us. That’s an inflation, you know, our dollar is not going as far when you’re sitting on 27, almost as soon to be 30 trillion in debt. And in the way of US government debt, the best way for them to be able to get rid of that is to having our currency that is. So if it if the US dollar becomes worth 50 cents abroad, then our 30 trillion really feels more like 15. And it’s a whole lot easier to pay that off. And so really, what we want to be looking at for our retirees is, as much as you might be able to be getting a little bit more yield, inflation’s can be way higher than 1.4%, you know, you’re going to be going out and you’re gonna be buying a fixed income product that where you are locked in for a 10 year time period. And what you’re saying in that situation, is that you’re guaranteeing to lose about six tenths of 1% every year and buying power for the next 10 years, that’s assuming that we stay at a 2% inflation rate. We’re slightly below that at the moment. But historically speaking, we’ve been at more like three, three and a half percent. So you would be locking in at a historically low level, and, and really hurting yourself. So to us, really, you need to be looking at this in the context of growing your portfolio, the fixed income and the fixed income world has historically been the ballast at the bottom of the ship to stabilize it, make sure your portfolio wasn’t too volatile, and so on. And unfortunately, in our current environment, somebody that is nearing retirement or in retirement, there’s very few people that are going to be able to go out and buy a fixed income necessary in order to supplement their income needs, in order to then be able to take risk with the the rest of the portfolio, and almost a riskless way, it’s it’s not there, they’re gonna have to put a large percentage of their money into the equity markets. And then they’re going to have to look for growth. And that’s where a firm like ours really comes into play Derby not to hurt myself, patting myself on the back here, but by the fact that we are as tactical as we are, and how we are able to protect as much to the downside, what we really talk about is what is risk. Now, by the end of 2008, we may back 100% of our clients money, but on a 2009. We did the same thing last year, I mean, we got out of the way of about 50% of the downside risk of the markets, I think if you would want to take our average client, they were down less than half of what was going on with the markets as an overall and a weighted average basis. So and looking at that, that we did our job. So as risk a one year downturn in the market, or a few months time a downturn in the market, where we recover within 12 months? Or is it a situation where somebody loses over a multi decade time period, their buying power, and they’re not gonna be aware of it. That’s the scary part. So we really want to be looking at here is being in a situation where maybe our advice is not as orthodox as what you’ll see in the books, but it’s the right advice. Now you got to grow your money ever again. Do you want to travel abroad at all, if you talk to any one of our clients, I would say hi on that list of goals is to travel. So if you’re traveling outside of the United States, your dollars would be worthless, you better be growing in order to offset that in order to be able to continue to travel the way that you want to enter retirement years. So that’s really kind of some of the advice that I would throw out.

Jeremy Witbeck:
Yeah, Jeff, I have a hunch This is going to be a topic that we revisit, just given the big movement here, but really appreciate you breaking down how fixed income works, how interest rates impact the fixed income market and why we should be paying attention to that. So as always, thank you so much for your time, Jeff, really appreciate your insights. So without everyone, thank you so much for listening and as always be happy, safe and be healthy.

Polaris Wealth:
Polaris wealth Advisory Group LLC is a federally registered investment advisor The information statements and opinions expressed in this material are provided for general information only and are subject to change without notice. This material does not take into account your particular investment objectives, financial situation or needs is not intended as a recommendation to purchase or sell any security and is not intended as individual or specific advice. It should not be construed as investment, legal or tax advice. before acting on this material you should consider whether it is suitable for your particular circumstances and if necessary, seek professional advice. Polaris wealth does not offer professional legal or tax advice. All information contained herein is believed to be accurate but accuracy cannot be guaranteed. advisory services are only offered to clients or prospective clients or florist Health Advisory Group LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Diversification does not assure a profit or protect against loss. Investing involves risk and possible loss of principal capital. No advice may be rendered by Polaris wealth Advisory Group LLC MSA client service agreement is in place