Time to rethink assumptions about interest rates–and income investing strategies
Reality has a nasty way of throwing investors’ assumptions onto the rubbish heap.
Take this one: The massive stimulus packages, central bank interventions, and government budget deficits will lead to a surge of inflation and rising interest rates.
That may still turn out to be true in the long run but the long run is showing a disconcerting tendency to recede into the distance these days.
It’s worth asking if the arrival of higher inflation and higher interest rates is now sufficiently delayed that the period between now and then deserves its own set of investing strategies. What kind of strategy? I’ll try to lay out the general outlines of one in this post.
China takes another step toward fighting inflation, ending its currency peg
The People’s Bank of China, the country’s central bank, will sell three-year bills for the first time since June 2008. The sale is a likely precursor to either an increase in official interest rates by the central bank or an end to the renminbi/dollar currency peg. In March 2007 the People’s Bank raised interest rates two months after selling three-year bills. The bank hasn’t raised interest rates since December 2007.
Issuing higher yield bills would be one way for the central bank to reduce lending by China’s banks.
Treasury yields hit 4% but the climb looks very gradual from here
Yields on the 10-year U.S. Treasury note hit 4% yesterday for the first time since June. And I think yields will keep rising in the months ahead.
But the United States is getting lucky.
Thanks to the damage the Greek debt crisis has done to the euro, I think the rise will be gradual indeed. Traders speculating on a spike in Treasury yields and a collapse in the U.S. dollar under the weight of the estimated $2.43 trillion in notes and bonds that the U.S. government will try to sell this year to finance a soaring deficit will have to wait until next year.
The Greek crisis, you know the one where it’s still quite possible that a member of the European Monetary Union will default on its debt, has had a profound effect on where the world puts its cash reserves. In the last quarter of 2009, the share of global currency reserves in U.S. dollars climbed to 62.1%, according to a March 31 quarterly report by the IMF (International Monetary Fund.) The euro’s share dropped to 27.4%. The shift toward the dollar and away from the euro reversed a trend that had seen overseas central banks looking to diversify away from the dollar.
And the dollar is getting a bigger piece of a bigger pie too.
U.S. interest rates are rising–and 4% on 10-year Treasuries is in sight again
Have you noticed that long-term U.S. interest rates have been inching upwards even as the Federal Reserve holds its short-term target at 0% to 0.25%?
Yields on the 10-year Treasury bond finished last week at 3.95% on Friday, April 2. That’s within an eyelash of the psychologically important 4% barrier last breached in June 2009.
I put the climb in long-term interest rates down to three causes.
How to maximize what your cash pays even when nothing is paying much of anything now
Got cash?
Maybe you’d love to invest it, but where?
The stock market seems pricy after a 70% rally from the March 2009 lows. And it’s been so up and down lately that it doesn’t inspire much confidence. So maybe stocks are just too risky for you. Or you’re close to retirement or those college tuition payments and can’t take a risk. Maybe you’d just like to wait. Or maybe you just need more income than most stocks pay these days.
Bonds are, well, no bargain. A three month Treasury bill pays just 0.12%. A two-year note pays just 0.79%. Inflation may not be very high at an annual rate of 2.6% for headline inflation (and 1.6% minus volatile energy and food prices) but it’s enough to eat up all the interest from those investments and more. (TIPS, Treasury Inflation-Protected Securities will protect you from inflation but the yields are really low (1.43% for a 10-year TIPS at recent auction) and they only protect you from inflation and not rising interest rates. I-Bonds, a savings bond that pays an interest rate that combines a fixed component, currently 0.3%, with an inflation-adjusted variable rate, current 3.06%, offer a higher yield but since the variable rate is pegged to inflation and not interest rates, the yield on these bonds won’t neceesarily go up if interest rates do. You also have to hold for at least 12 months. (After that and until you’ve held for 5 years you lose the last 3-months of interest when you sell.)
You could lock your money up for decades and get 4.56% in a 30-year Treasury bond but 30 years is forever. And besides interest rates have to go up from today’s lows and that means bond prices will be coming down, probably fast enough to eat up all the interest that bond pays and more.
A certificate of deposit (CD) would make sure you get your invested capital back intact but the highest rates I can find for a one-year CD are 1.88% (at Eastbank) and 1.7% (at Tennessee Commerce Bank). That doesn’t even beat headline inflation.
Might as well keep it buried in the back yard—except that loses out to inflation too.
Here’s my advice: Think short term. It’s the best way right now to maximize long-term income.
