When analyzing the current state of the bond markets, financial advisers may be concerned about the potential for interest rates to rise faster than the markets have priced in. While this development may not be probable, it is certainly possible – and is, therefore, worthy of exploration and discussion.
What factors might drive up interest rates, thereby negatively impacting bond markets? Rapid wage inflation and consumer product inflation could factor into a decision by the
Federal Reserve to increase interest rates more precipitously than expected.
At its July 2017 meeting, the Federal Reserve's Federal Open Market Committee found that "[c]onsumer spending appears to be rising across a majority of Districts." And now, in July 2017, the unemployment rate is the lowest it has been since May 2007, at 4.4%. Tight labor markets combined with potentially higher consumer spending could beget higher inflation.
If wage inflation were to suddenly increase, the Federal Reserve, with its dual mandate of facilitating economic growth while simultaneously controlling inflation, may have to consider raising interest rates more aggressively than the modest 0.25% hikes it implemented in March and June.
An additional trigger that could precipitate a greater-than-expected interest rate hike is personal consumption expenditures inflation. If the cost of consumer products suddenly rise, consumers would be less inclined to purchase them – which could propel the Fed to make a more dramatic rate increase.
If interest rates rise faster than anticipated, any or all of the following causal outcomes could occur. An economic domino-effect plays out, and potential if/then clauses abound.
Higher interest rates lead to higher borrowing costs, so mortgages would become more costly and business loan interest rates would rise. Some homebuyers might postpone making real estate investments, and small business owners may be disinclined to take on debt. If business owners do not borrow, production may fall. This could result in a reduced workforce and could adversely affect spending.
Since bond prices move in the opposite direction of interest rates, higher interest rates cause long-term bond values to decline. Unless held to maturity, long-term bonds are impacted by interest rate fluctuations over a longer period than those with shorter maturities.
Investors in bond funds can be hit particularly hard when interest rates rise, and are more likely to liquidate shares with rate increases. To meet redemption requests, fund managers may feel pressured to sell bonds before maturity – potentially resulting in losses for shareholders who choose to stay in the fund.
And yet there is also the possibility that with higher-than-anticipated interest rates, good
dividend-paying stocks could become less attractive. With higher borrowing costs, companies will owe more interest on their debt, which will result in smaller profits. Investors accustomed to high returns on
dividend-paying stocks may bristle at the reduced returns brought on by interest rate increases and may choose to move to safer, more predictable investments such as bonds.
A hike in interest rates could also cause company stock valuations to decrease as a result of future cash flows being discounted at a higher rate. This too could make bonds more appealing to investors.
Even your average warehouse, office building or skyscraper could be hit hard by a jump in interest rates. If interest rates were to rise quickly, capitalization rates would increase and the value of commercial real estate would decrease. When property owners owe more each month in debt repayment, they will be less profitable.
The relational nature of economics is clearly evident when a sudden interest rate hike is pondered. If interest rates rise more quickly than anticipated, any number of outcomes may occur: higher borrowing costs, lower business borrowing, decreased production, declines in long-term bond values, movement away from
dividend-paying stocks, reduced stock valuations and losses in commercial real estate. Here's hoping that wages and personal consumption expenditures remain constant so that interest rates increase only modestly, and not precipitously, over time.
Michael Joyce, founder and president of JoycePayne Partners of Richmond, Virginia and Bethlehem, Pennsylvania, is responsible for overall investment strategy, management of investment portfolios and financial counseling services. He can be reached at [email protected].
