Interest Rates Are Rising Because The Economy Is Strengthening

Interest Rates Are Rising Because The Economy Is Strengthening

I have been predicting higher interest rates, a stronger economy, and healthy returns in equities for a long time. For years I’ve gone against conventional wisdom, which typically worries that rising interest rates will choke off growth. Conventional wisdom, however, ignores an important detail: whether rising rates are the result of aggressive Fed tightening or not makes a big difference.

 

Today’s rising rates are not being driven by the Fed, since monetary policy is still relatively neutral. To date the Fed has been following the market, moving rates higher in baby steps. The real Fed Funds rate is only marginally above zero, and neither the real nor the nominal yield curve is inverted. Liquidity is still abundant, to judge by the very low level of 2-yr swap spreads. Credit risk is relatively low, to judge by credit spreads. Financial conditions are optimal. Furthermore, regulatory burdens have declined significantly, as have tax burdens. What’s not to like?

 

The higher rates we are seeing of late are being driven not by higher inflation expectations, but by higher real yields. This is healthy. A stronger economy goes hand in hand with higher real interest rates. A stronger economy is being built on a foundation of rising confidence and increased after-tax rewards to work and risk-taking. As I mentioned in a recent post, rising confidence is reducing the demand for money and safety, and that goes hand in hand with falling prices on safe TIPS and Treasuries and, ipso facto, higher yields.

 

Today’s September ISM surveys of the manufacturing and service sectors were undeniably strong. These surveys reflect fairly recent activity, and the results corroborate the solid numbers we have seen in regards to small business optimism, hiring plans, and jobs growth.