People have been talking about interest rates going up for about 8 years now.
Every time I hear someone froth on about rates going higher, the first thing I ask them is, "which rates are going higher". That is to say, the "interest rate curve" is a long one, from overnight lending rates all the way out to 30 year government bonds. Central Banks typically affect the overnight rate that they will lend money at to qualified banks. So therein lies a big difference between overnight rates going up or down and a 30 year rate (government bond yield) going up or down. We call the yield difference from overnight all the way to 30 years, "The Yield Curve" and understanding it is key (it helps when you traded it for decades for a profession/income).
I won't go into a huge explanation on the yield curve here but suffice to say that the yield curve doesn't move in lock-step up and down depending on what a central bank does in the overnight market. For instance, part of the reason why we have liked 30 year government bonds so much the past few years is that: 1) we did not believe there was any inflation in the global economy (and inflation is the enemy of all bonds, especially 30 year bonds) and in fact we believed there was likely deflation building from East (Japan) to West (currently Europe, but possibly hitting our shores in N Am) and 2) if a central bank (the US Fed) decides to raise the overnight rate, that would likely mean they are getting ahead of the inflation curve so inflation would not resurrect it's ugly head and destroy 30yr bonds...in fact, the yield curve would flatten where 30 year bonds do very well...sort of a win-win, in our opinion.
With that said, I noticed something strange going on with short term (90 day) US interest rate vehicles.
First, we will look at 3 month Libor. This is the 90 day London Interbank Offering Rate (LIBOR) or the rate at which banks will lend to each other for 3 months. This is considered credit risk as the lending bank is taking the credit risk of the borrowing bank. As you can see from the chart below, it has gone up pretty substantially, twice, over the past year, as the US Central Bank (the Fed) has actually raised their Fed Funds and Discount Rate targets last Dec and then jawboned or talked it higher recently (white and red arrows). So with the Fed moving once and talking the overnight lending rate higher, I suppose seeing this chart move from the bottom left to the top right makes sense...
Now the next short term vehicle to look at is what is called the TED Spread. This is the LIBOR Rate (also referred to as Eurodollar Rate) minus the US Treasury Bill Rate. The TED Spread is a measure of stress or risk in the overall market place. Think about it this way - A 90 day Treasury Bill is called the Risk-Free Rate and is considered to be about the safest investment vehicle one can purchase. But a 90 day Eurodollar or LIBOR loan means the lending bank (investor) is assuming the credit of the borrowing bank...ie...credit risk, and therefore much riskier an investment than the full faith and taxing authority of the US Treasury Department through a Treasury Bill.
So if the TED Spread is moving higher, it means that the LIBOR Rate is moving higher and faster than the Treasury Bill Rate...investors want to own Treasury Bills (keeps the rate lower) and will only lend LIBOR if they get paid more (higher lending rates).
Here is the TED Spread over time with some periods of stress/risk and you can see what happened to it:
An explanation of the big spikes in the middle of the chart first (apologies if it doesn't read well but I gave up trying to adjust it the captions):
As you can see, during times of stress, banks and other financials that rely on short term funding for their operations find the following: borrowing/lending rates go higher (LIBOR) and the risk-free rate (Treasury Bills) go lower, at least comparatively.
So what is happening today? Well LIBOR is moving higher( Chart 1) as one would expect due to the Fed moving rates up last Dec and talking them higher today. But the TED Spread is also moving higher too as you can see in Chart 2 in the bottom right with the red arrow.
Why on earth would LIBOR be moving higher than Treasury Bills if the Fed was raising rates because the economy was so strong? Answer - maybe the economy is not so strong and the market senses risk/stress due to a policy error? If the economy was so strong that the Fed had to raise rates, don't you think the TED Spread would be dropping/compressing? Think about what is going on with European Banks alone for an explanation as to why LIBOR is climbing faster than US Treasury Bill rates but our view is that if,as and when the Fed does hike rates again, it will be a policy error extraordinaire and it will likely lead to a recession (every US recession has started with the Fed raising short term rates so why would this one be different?). See chart below (shaded areas are US recessions and the yellow line is the 2yr Government Bond...considered short enough to be a proxy for short term rates and Fed Fund rates increases.
So to conclude this convoluted mess of a blog (sorry, I originally thought I would write 1-2 paragraphs and throw up 1 chart) --> Scott says it pretty well every week in our Webinar, "Bonds (and Treasury Bills) lead" so we need to take notice of what the TED Spread is telling us...ie...there is stress/risk in the system and a policy error may be on the horizon. We continue to position our portfolios for such a risk/stress or policy error which means: higher cash weightings, long government and corporate bonds further out the yield curve, under-invested in global stock indices (beta) and selectively invested in our Tactical (alpha) model (mix of well-researched stocks, bonds, converts and preferred shares).