US Interest Rates Are Rising

Over many years investing in shares benefitted from falling and low interest rates. The yield on 3-Month Treasury Bonds was between 0% and 0.2% from January 2010 to about September 2015. From then it started to increase moderately, then faster. As of market close on 02 March 2018 this number is 1.63%. This still appears to be a small number but the diagram shows how this actually does indicate a sharp rise in short term interest rates. The yield on 3-Month Treasury Bills is often used as the reference for the yield of a risk-free investment. There is a general opinion that the likelihood of the US government to default is close to zero for a three-month time frame.

Another metric worth monitoring is the yield on 10 Years US Treasury Notes. These have been falling until about March 2016. Since then they have been moving up as well with the latest number being 2.862% (as of market close 02 March 2018).

Why is this important? Yields increase as the price for bonds and bills decrease. For investors it means that as the yield on investments with a lower risk increases, they either pull out money from investments with higher risks or they need the investments with higher risks to create a higher return. Shares are generally considered to be an investment option with a higher risk than T-bills or government bonds. Given that the US share markets have enjoyed gains of almost 20% in 2017, their valuations have now reached lofty levels. Rising interest rates will put pressure on shares prices as gradually more investors will tend to sell shares and invest in lower risk assets.

So far, some companies have been able to stem the tide somewhat in that they have raised dividends and share buybacks. Both are ways to return money to shareholders. The total return, being the combination of share price increases plus dividend payments and other distributions (e.g. stock splits), improves. However, this works only so far. Some of the dividends are special one-off dividends. And even though the tax reform in the US helps companies to reduce their tax bill, the amount of interest they have to pay increases. The low interest rates over many years was a big incentive to take on more debt in the balance sheets. As the interest rates increase, this can backfire and offset the gains from reduced tax payments.

Also, some companies experienced windfall profits as they need set aside less reserves for future tax obligations. Some have opted to give their employees a pay increase which also increases the cost base.

And then there is the Federal Reserve. It is expected that they will continue to increase the interest this year. Most commentators seem to expect three or four increases in 2018. We don’t know yet by how much. In any case they have several reasons to increase the interest rates. Inflation is picking up and this is driven by several factors including the low rate of unemployment in the US driving wages up and also the weak dollar that drives up prices on everything that needs to be imported. And that is even before tariffs are imposed, tariffs currently known (steel and aluminium) and potential future ones. Even the “most American” of cars consists of at least 50% parts that are imported.

Inflation, the weak dollar and tariffs are potential topics for future posts, so we won’t go into further details here. Suffice to say, interest rates are more likely to continue to rise than they are to stay flat, let alone fall. And this is likely to be a factor for the time being that puts a downward pressure on the US share markets.

We believe, though, that our Optarix US Portfolio is in a good position to do as well as its benchmarks if not better. Stay tuned and observe how all of this will play out. It’s exciting times!

Happy investing!