Was Everyone Listening to Janet Yellen Last Week?
March 6, 2017
The days of cheap money may be ending soon. The head of the Federal Reserve Bank, Janet Yellen, went so boldly as to tell the press that she thinks rates should be raised at this month’s FOMC meeting. So much for let’s have a discussion and see if we all really agree. No, this week the head of the Fed got in front of the train and surprised the market a bit with the announcement that the Fed will raise short-term interest rates at the March FOMC meeting. The Fed had previously only stated that three interest rate increases were probably in order for this year. Janet’s proclamation brought some fear into the market that rate increases may occur sooner than expected due to indications of a strengthening U.S. economy. The equity markets reacted with barely a yawn as the Trump rally from November continued. The government bond market however did see 2-year US Treasury rates rise 17 basis points and 5-year U.S. Treasury rates move up 21 basis points. The news from market pros on all the media sources quickly turned from an equity focus to a bond focus.
Why the concern over rising interest rates? This past year, U.S. companies have been massively borrowing money in the bond market since the cost to borrow has been historically cheap. In addition, investors have been willing to take on more and more credit risk at ever lower and lower yields. The “risk premium” that investors should be getting paid for taking on more and more credit risk has evaporated. Simply stated, some believe investors have been willing to take on greater risk than they normally would and are not being paid to take on that risk. This action violates one key rule of investing: the more credit risk you take the more return you should get.
The days of cheap money may be ending. We are beginning to see some traditional lenders (and don’t forget that investors who buy bonds are lenders) like banks beginning to tighten up on the credit standards to borrowers. The first wave of this tightening has begun in the real estate space. Stories abound that lenders have completely backed away from certain developmental real estate deals and many other lenders are starting to raise their interest rates and demand higher down payments or additional equity for the financing of deals. Loan rates are still very low by historical standards but there does seem to be a reality check going on in the lending and bond market that suggest the days of super easy money are in the rear view mirror. Every week in this commentary we publish market statistics including the interest rate of the high yield index. To give you a sense of how much this index has moved, it closed on Friday at a yield of 6.00%. One year ago the same index was at 8.86%. Simply stated this means an investor one year ago would get paid almost 9% by investing in high yield but today you will only get 6%. Remember to get paid if you are going to take risk and credit risk is a big risk.
Carl Gambrell
