How Not to Predict Interest Rates

We continue our hiatus from capital destruction to look further at interest rates. Last week, our Report was almost prescient. We said:

The first thing we must say about this is that people should pick one: (A) rising stock market or (B) rising interest rates. They both cannot be true (though we could have falling rates and falling stocks).

We write these Reports over the weekend. At the time of last week’s writing session, Friday’s close on the S&P was 2757 (futures). Monday this week saw a crash, with the S&P down to 2529 at the low point in the evening. That is a drop of -8.3%.

We are not stock prognosticators, and we will neither tell you “short the market” nor “buy the dip”. We have a different point to make.

Rising interest rates, by a variety of mechanisms, cause stocks and all asset prices to go down. We have touched on a few in this Report. One is that investors have a choice between the risk-free asset—the Treasury bond—and anything else (note: the Treasury bond is not risk-free, but if it defaults then everything else will be wiped out in the collapse). Why would they accept a lower yield on stocks along with the greater risk? Another is that corporations can borrow to buy their own shares. Management may do this if the interest rate is lower than their shares yield. But they can sell shares to pay off debt if the shares have lower yield than the interest rate.

Let’s look at a few more.

Consider home buyers. It is well understood that most people are monthly payment borrowers. That is, they have a budget for the mortgage payment and fit the house to that budget. If the typical middle-class family can afford $2,500 a month, that’s it. When the 30-year fixed mortgage rate was 3.4% in 2013, this family could afford to finance $565,000. Today, at 4%, the amount is down to $525,000.

Interestingly, the 30-year mortgage rate illustrates our ongoing theme. Demand for credit is soft. In a time when 12-month LIBOR was under 0.8%, the 30-year mortgage rate was 3.4%. Now that LIBOR has risen to 2.3%, a gain of 1.5%, the 30-year mortgage is going for 4%, or only 0.6% higher. If the mortgage had increased by the same 1.5%, it would be 4.9% and this family would be down to financing $472,000.

And it gets worse. In a falling rates environment, many people take Adjustable Rate Mortgages (ARMs) with a balloon payment at the end, which is another form of duration mismatch. So the relevant 2013 comparison is not 3.4% but 2.6%. At 2.6%, someone willing to use an ARM—we will call him the marginal home buyer—could finance $625,000.

In rising rates environment, we assume that most people will want to fix their mortgage rate. And now there is a consensus, from Fed propagandists to the gold bugs and everyone in between. Everyone thinks that rates are rising. So the relevant comparison for amount financed between 2013 and today is $625,000 to $472,000, a drop of -24%.

Let’s move on to the automakers. At least in the US (we don’t know if this occurs in other countries), they are advertising 0% to finance a new car for 72 months. Of course, the carmakers cannot borrow for free. Let’s assume they are playing the duration mismatch game, and using 1-year maturities, because it’s a lower rate. The disadvantage of financing a 6-year loan with a 1-year liability is that you must roll the liability five times, on each anniversary. The advantage is that the rate is lower.