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Rising rates and the weakest link

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Thomas H. Luster, CFA, Director of Quantitative Strategies, Diversified Fixed Income, Eaton Vance Management and Stewart D. Taylor, Diversified Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - Markets appear to be coming to grips with the notion that interest rates may be moving higher as the Federal Reserve and other central banks signal their desire to hike rates and tighten financial conditions.

      Indeed, the fundamental case for higher intermediate- and long-term rates is very convincing, particularly this late in the economic cycle. In this post, we'll distill the fundamental argument for higher rates into five main points.

      We will also look at the historical behavior of U.S. 10-year Treasury yields for any clues on what the path higher might look like. Our analysis suggests that over the last 30 years, sharp rate increases have been interrupted as borrowing costs rise and break the "weakest link" in either financial markets or the economy.

      Five fundamental reasons for higher rates

      1. Economic strength: The massive global monetary stimulus of the last decade is finally being coupled with powerful domestic fiscal stimulus such as tax cuts. The economic consensus is that growth has finally achieved the ever elusive "lift off." For instance, individual and corporate tax cuts have resulted in the strongest year-over-year growth rate in U.S. GDP (+5.4%) since the third quarter of 2006, and manufacturing as measured by the Institute for Supply Management (ISM) is hitting rarefied levels seen only once in the last 30 years. Additionally, corporate earnings are impressive, and both businesses and consumer confidence are extremely high, although the readings may come down a bit after the recent market volatility.

      2. Inflation: Historically, strong growth at this late stage of the economic cycle, coupled with the extreme tightness in the labor market, have reliably generated above-trend wage growth and inflation. Recent rate increases have been driven by higher real rates, reflecting stronger economic growth expectations, and not by inflation fears. We view the current inflation risk premium as modest by historical standards. It seems likely that investors will demand significantly higher inflation compensation if the typical late-cycle pricing pressures begin to appear.

      3. Monetary policy: After leaving fed funds rate near zero for seven years, the Federal Reserve has increased the rate by 200 basis points during its latest tightening cycle. Also, the Fed is projecting four more quarter-point hikes between now and December 2019.

      4. Supply: The federal budget deficit is ramping higher. Simply put, higher deficits mean commensurately higher Treasury issuance. Bonds are subject to the same forces of supply and demand that determine pricing in any other asset. All things being equal, too much supply results in lower bond prices and higher yields to stimulate demand. The Congressional Budget Office (CBO) projects that the 2019 deficit will be $981 billion, and that federal debt will rise from the current $21.5 trillion to $34.0 trillion by 2028. Also, the Fed is letting its portfolio of bonds bought since the financial crisis roll off, effectively increasing supply even further.

      5. Fair value: Bond buying by global central banks and a general lack of alternatives to invest the liquidity has compressed bond yields far below their traditional measures of fair value. All things being equal, bond yields normalizing to what has historically been fair value would add an additional 1-2% to their yield. Importantly, 10-year Treasury yields have historically closely tracked nominal GDP. If nominal GDP is rising, we see a strong case for rising rates.

      Charting a course to higher rates

      Although our view is that the decades-long downtrend in rates ended at the 2016 low, we think it's likely that a new uptrend in rates will take time to develop -- and that when it does, the move won't occur in a straight line. In other words, we believe there are likely to be significant "corrections" within the uptrend.

      Since 1986, there have been seven "mini-cycles" of higher 10-year Treasury yields within the broader downtrend. Each of these instances has ended with a financial or economic event. The important takeaway is that each cycle has ultimately translated to lower U.S. rates.

      In fact, this pattern has held since the mid-1970s. Yet, a subtle change to this pattern has emerged over time. And that is that the economy and markets seem to have become more negatively sensitive to rising rates.

      Blog Image Treasury Chart Nov 5Blog Image Treasury Table Nov 5

      The weakest link

      Today, in an economy that is both highly financialized and truly global, we believe that sharply rising rates are likely to break the weakest financial or economic link. In past cycles, the weakest link has been the savings and loan industry, or dot-com stocks, or subprime mortgages. Of course, it remains to be seen whether another period of rising rates will break another weakest link, and where it might be.

      The interconnectedness of global finance insures that problems in one market have the ability to easily transfer across both borders and asset classes.

      The 10-year US Treasury yield is now 170 basis points higher over roughly a two-year timespan. Four of the last five "shock" events have been generated by smaller moves, and nearly a decade of extremely easy monetary policy has created a number of potential candidates for "the weakest link."

      Bottom line: We believe the fundamental case for intermediate rates rising is the strongest we have seen in decades and shouldn't be discounted. But while a specific event is difficult to predict, rising rates (irrespective of the beginning level) have reliably provided a catalyst for crisis and by extrapolation, lower rates.