Altus Insight July

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor

Date: July 31, 2019
FR: Forrest Jinks
RE: ‘Of Interest’ Redux

 

Smack dab in the middle of summer isn’t likely a time when people want to read esoteric musings on investing. And frankly, it can be more difficult for me to write articles requiring considerable thought and research when there is so much fun stuff going on. It isn’t just summer fun that is distracting me right now. We are closing on two purchases in the next two weeks, with another purchase scheduled to close by the end of August, the last of which we haven’t even started raising investment yet. So, in honor of summer, this Insight will be shorter than most. Just a short discussion on two different topics relating to interest rates.

Inverted Yield Curve – Why Does it Matter: Many people think that an inverted yield curve causes a recession. That is not accurate. Correlation is not causation. What a yield curve does do is message to the world what investors collectively are anticipating future economic activity to be. A steep yield curve, meaning long interest rates are considerably higher than short interest rates, indicate investors believing there will be lots of good investment opportunities in the future, hence they are requiring higher returns (interest rates) to hold long dated debt versus short dated debt. A flattening yield curve indicates the assumption that opportunities to invest in the future are diminishing. By the time a yield curve inverts it means that investors are assuming there will be worse investment opportunities in the future than there are currently. Most investors and market commentators will consider the curve to be inverted when a ten-year risk-free rate (using Treasuries in the US) is less than the three-month rate (using T-bills in the US). Because there is such a range of “risk-free” investing time periods, a ten-year rate is actually a compilation of all the shorter term interest rates (the same holds true for a 7 year, 5 year, 3 year, etc. rate as well). Said another way, by using the yield curve we determine what investment returns investors expect for each year of their investment. We do the same thing when we roll out a new investment. There is a pro forma that breaks out the expected returns by year. The following shows what investors expect to receive in returns by year when purchasing a ten-year treasury (as of July 26th, 2019). Since there aren’t bonds available for each of the ten years, missing years will use the shorter bond rate:

  1. One Year Rate – 2.00%
  2. Two Year Rate – 1.86%
    1. Imputed rate of year two – 1.72% (1.86% * 2 years minus 2%)
  3. Three Year Rate – 1.83%
    1. Imputed rate of year three – 1.77% (1.83% * 3 years minus 2% minus 1.72%)
  4. Five Year Rate – 1.85%
    1. Imputed rate of year five – 1.99% (1.85% * 5 years – 2% - 1.72% - 1.77% - 1.77%)
  5. Seven Year Rate – 1.95%
    1. Imputed rate of year seven – 2.41% (1.95% * 7 years – previous years)
  6. Ten Year Rate – 2.08%
    1. Imputed rate of year ten – 2.33% (2.08 * 10 years – previous years)

An imputed interest rate of 2.33% for year ten tells us two things:

  1. Since investors generally expect higher returns for returns farther out in the future than they do for returns nearer in the future, inflation expectations are extremely muted.
  2. Investors that invest in treasuries for capital appreciation instead of risk-free cash flow are expecting short term rates to drop (Fed intervention). Rates and bond prices move in opposite directions. Lower short-term rates should increase demand out farther on the yield curve. The increased demand results in lower interest rates farther out on the curve as well. Those lower rates would result in higher prices. A change in interest rates affects pricing on longer dated debt more than shorter dated debt.

By looking at the expected interest rates for each year of the yield curve we can also extrapolate that investors are expecting a worsening investment environment through roughly year 5 with improvements thereafter.

Has the Fed Lost its Way?: By the time you read this article the Fed will have already announced a cut to the overnight rate (Federal Funds rate). Or at least that’s what the market is pricing as a near certainty. It will be the first cut in ten years. I cannot pass judgement whether the rate cut is a good idea or not. The Fed has often in the past been accused of being reactionary and closing the barn doors after the horses are already out of the barn. With this rate cut they would be trying to buck that historical trend. Maybe this does result in a softer economic cycle landing, or at an extreme, a bypassing of the recession part of the cycle all together. However, there are counter arguments worth considering:

  1. The Fed’s credibility has been built on it being “data dependent”. The current data does not justify a rate cut, which even Fed governors admit. Some are calling this an insurance cut. Again, maybe this is the best thing for the economy, but isn’t data dependent.
  2. Inflation hasn’t hit Fed targets, but it is still well above zero, even in the manner it is currently being measured by the Fed. Looking at inflation while including investment asset prices and consumer goods net of non utility added hedonic adjustments paints a much different picture with high and increasing prices throughout the economy.
  3. Unemployment is near record lows.
  4. There is substantial evidence that the low rates of the past decade have exacerbated the rich/poor/earnings gap as investment portfolios (owned mostly by the rich) have roared higher while basic necessities have gotten more expensive (health care and rent for instance) without a corresponding increase in earnings. There is no evidence that increasing easy money monetary policies will do anything but amplify the same things the easy money policies have done thus far, which is to push asset prices higher without benefiting main street.

Time will tell.

 

Enjoy the rest of summer and your vacations that remain to be had. August is generally a time of a relative lull in the markets. Then fall kicks in and things get interesting. I am looking forward to the excitement.

Happy Investing.

Forrest Jinks

Altus Equity Group, LP

off: 707/932-5887

fax: 707/544-2972

www.altusequity.com

 

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.