Higher Rates A Natural Consequence Of Economic Expansion

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“Davidson” submits:

The recent trend in the media is to fear higher rates. Actually, history indicates that higher rates are correlated to higher economic growth as shown in Chart 1

But, it has never been about the actual rate level itself. We have had economic expansion with high rates in our past. What is more important are credit spreads or the ability of banks to borrow at low cost and lend at levels which are both profitable and build reserves to cover potential defaults.

Chart 2 shows the S&P 500 (INDEXSP:.INX) vs. T-Bill & 10yr Treasury Rates. The difference in the T-Bill Rate and that of the 10yr Treasury is called a ‘credit spread’ or a ‘yield spread’ and can be used to explain much we have seen in our economy  through history.

S&P 500 Treasury rate changes Higher rates

Bank profits and lending activity is highly dependent on regulators and the cost of funds vs. the return on lending. Banks’ cost of funds is represented by T-Bill rates. Bank returns are based on the rates received for lending at various maturities with the longest maturities being mortgage lending carrying higher profits. The average 30yr conventional mortgage rate tends to be 1.6% higher than the 10yr Treasury rate. In+today’s market with the 10yr Treasury rate +at 2.75% we are seeing 30yr conventional mortgages at the 4.5% level. Bank lending began to expand as rates rose last year.

Chart 2 shows that credit spreads widen during economic downturns as investors sell stocks and buy T-Bills in a flight to safety. But, wider credit spreads themselves do not automatically stimulate increases in lending. During recessions banks reduce lending and correct excesses from the prior ending boom and in the current recession had to raise capital to meet higher standards from regulators. For a period, this meant that lending was stifled till capital levels satisfied the new regulations. After a period of adjustment, banks again expand their lending. However, our recent recession also saw the Federal Reserve force long term rates lower in an effort to benefit consumers. This effort was titled ‘Quantitative Easing’(QE)! The net impact was to lower credit spreads and stifle bank lending which was did not have the intended economic stimulation.

Last May-June 2013 saw a 10yr Treasury rate rise as the Federal Reserve discussed ‘tapering QE’. The net result was a slowing of mortgage refinancing but an expansion of new mortgage issuance as one would expect as banks were more able to offer lending as credit spreads widened. Investors, as has been typical, misinterpreted these events. Higher 10yr Treasury Rates while T-Bill Rates remain low is good for lending and economic expansion.

Higher 10yr Treasury Rates while T-Bill Rates remain low is good for lending and economic expansion.

What all this tells us is that we should 1) expect higher rates as the economy expands and 2) we should also expect credit spreads to widen which historically expands bank lending and economic activity. Economic activity slows with contracting credit spreads for which we have a historical minimum of 24mos of warning. You can see this in Chart 2.

The net/net is that it is not rising rates per se which slow economies, but the narrowing of credit spreads which stifles lending to which we must pay attention.

At the moment, all looks positive for Equity investors (SPDR S&P 500 ETF Trust (NYSEARCA:SPY)), but negative for Fixed Income investors.

Don’t Be Afraid Of Higher Rates; Instead, Embrace Them By ValuePlays

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