Contradictory US rate risks

Markets are getting ready for rises in US interest rates, which poses the questions: what’s the problem, and what can investors do about it?

At its recent meeting the Fed signalled that it now expects to raise the fed funds rate by half a percentage point by the end of 2023, and that the rate should be around 2.5 per cent in the long run. 2023 seems a long way off, but bond yields depend upon the expected path of short-term rates, so even quite distant rate rises should move yields today – and of course the rises could be less distant if inflation proves a bigger threat than the Fed currently believes.

For investors, this poses two diametrically opposite risks.

One is that high rates could be part of a strong upturn, powered by fiscal expansion, which sees sustained growth and inflation. In this scenario, bonds would sell off badly but the US dollar would rise as investors are attracted by higher US rates.

This would see equities do well because the same strong growth that causes the Fed to raise rates also raises appetite for risk. And because they are more sensitive to investor sentiment than most shares, emerging markets would benefit from this. A stronger dollar would, however, hold them back to the extent that higher costs of raw materials and increased costs of servicing dollar-denominated debt damage their economies.

One asset that would do badly in this scenario is gold. Because it pays no income, the metal becomes less attractive when yields on other assets rise. For this reason, there has been a massive negative correlation between US bond yields and the gold price. Post-2000 relationships suggest that a one percentage point rise in five-year Treasury yields would wipe $270, or 15 per cent, off the price of gold.

Rate rises caused by a strong growth are therefore terrible for gold and bonds but OK for equities.

There is, however, an opposite danger – that even mild rate rises could significantly weaken the economy. Before the pandemic, economists feared that the US – and indeed developed economies generally – had fallen into what Harvard University’s Larry Summers calls “secular stagnation” – a phase of weak trend growth in which ultra-low rates are needed to support the economy. The pandemic might even have exacerbated this problem, as the legacy of higher corporate debt and the scarring effect on animal spirits of a deep recession could depress investment intentions. If so, even a small rate rise could trigger fears of a sharp slowdown in growth especially if it comes as the impact of President Biden’s fiscal stimulus is fading.

Such a scenario would be good for bonds, as investors anticipate no further rise in rates and perhaps even cuts. It would therefore also be good for gold. But it would be bad for equities as fears of slower growth depress appetite for risk. In other words, this scenario has exactly the opposite investment implications from the inflationary scenario.

It’s in this context that we should regard the recent stability in financial markets: the S&P 500 is little changed since early May, and even after their recent rise five-year Treasury yields are still lower than they were in April.

Such stability is a sign that investors disagree: prices are stable when buyers quickly find sellers and vice versa. A big reason for this disagreement is that investors aren’t sure which is the greater risk – that the Fed is under-rating inflation in which case bond yields might rise a lot; or that it is over-rating it and so risking unnecessary damage to a fragile economy.

And herein lies the danger. Stability can be brittle. If the balance of opinion were to shift towards either of these scenarios, volatility would rise. This could be triggered by something innocuous: it is fears about other investors’ fears that drive prices, not just underlying reality.

Of course, it is possible that neither scenario emerges, and that the Fed judges the path of rates just right, thus giving us sustained non-inflationary growth. Even if the Fed achieves this feat, however, markets might not have faith that it will do so – in which case one of our scenarios emerges.

All that investors can do about this is to hold a balanced portfolio: equities to give us exposure to the strong growth scenario, and gold and bonds to protect us from the weak – plus of course plenty of cash to protect us from the danger of a combined flight out of both equities and bonds.

Such a portfolio will very likely see losses on some components of it. But that’s the point of diversification. What matters are our portfolios as a whole. And we can make these reasonable resilient to interest rate risks.