In February, market interest rates, which are set by buyers and sellers in the bond market, continued their rapid rise from year-end 2020, with the ten-year US benchmark rate rising from 0.93% to 1.40%. Many in the financial media have begun to attribute down days in the stock market to this move to higher rates. We at PPA are quick to note that these rates remain very low and do not provide enough interest income for most long-term investors, which in turn forces them to look for other, riskier sources of investment return (such as stocks) to meet their goals.
We do agree that the financial markets are impacted by rising interest rates, but those impacts are varied and often create countervailing price movements.
- The most direct impact of rising rates is on the prices of bonds with maturities measured in years rather than months. Invariably, those prices decline, and longer-maturity bond prices decline more than shorter-maturity bond prices do. The bond funds PPA uses in client portfolios typically consist of a mix of bond maturities, not exceeding six years, with many between zero and three years. The offset to these price declines is a rise in the interest that investors receive from their bonds. But it is important to note that it takes a longer time period for the increased interest received to make up for a potentially rapid price decline in a short time frame. Further, longer bond maturities typically pay more interest while still outstanding than do shorter bond maturities. In general, the idea that bonds mature is an important factor as to why their price volatility is considerably lower, historically, than stock price volatility.
- More subject to debate is whether the rising rates are signaling an improving economy. Some days the media reports improving economic conditions, like rising income and consumer spending, and other days the economic news is bleaker, with increased unemployment claims (see also page 7 for details about the improvements from the February employment report).
- The financial media is also focusing on the financial market’s anticipation of an improving economy based on the increasing number of people receiving a vaccination against the coronavirus.
- Another connection between rising interest rates and an improving economy is the conventional wisdom that if the economy grows too strongly, the Federal Reserve will step in and increase the short-term rates it controls, in order to slow the economy and avoid harmful inflation. Inflation reduces the purchasing power of a given amount of money, and if it increases too quickly and too much, central banks are tasked with controlling inflation. However, during this pandemic, “the Fed has consistently indicated its desire to keep rates low, focusing on improving the economic and employment situations, and not being overly concerned about inflation and/or rising budget deficits. The real fear of bond investors is that an economy that grows too strongly has the potential of bringing about a re-emergence of harmful inflation….Typically, when an economy has slack, as the US economy does now, growth can occur with inflation fears remaining subdued” (quoted from our January 2021 Comments).
Some additional media quotes on this situation follow:
From The Economist Magazine (2/13/21, page 10): “The debate about whether high inflation will emerge out of the pandemic is becoming more pressing… Coming price acceleration could be worrisome for several reasons. One is that it weakens the hand of those arguing for more fiscal stimulus in places that need it… The Fed has promised to keep interest rates low and to keep buying bonds because it wants to overshoot its 2% target… Higher rates also hold deep implications for financial markets. Almost everything about today’s financial landscape is premised on central banks keeping interest rates low for a long time. Cheap money lies behind the idea that the government can spend however much it likes – including Mr. Biden’s planned infrastructure bill – and underpins today’s sky-high stock market values and abundant credit. “
Fed Chairman Jerome Powell, in an online question and answer session hosted by the Wall Street Journal on March 4th (see NYT, 3/5/21, page B1), delivered the message of “how cautious the central bank plans to be in dialing back economic policies – low interest rates and large scale bond buying – that are meant to help the economy recover from the painful coronavirus shock…. Market players have begun to speculate that the Fed might lift interest rates earlier than expected, even as the central bank’s top officials pledge patience…. The Fed Chair did acknowledge watching market fluctuations,… and that sharp bond market moves would create concerns of making credit expensive, and threatening the Fed’s goals.” He also drew the distinction between a short-term pop in inflation and a sustained acceleration, as well as to note that “employers report 10 million fewer jobs than before the pandemic, leaving lots of room for a labor rebound.”
More about Bitcoin
In this updated discussion of Bitcoin, we begin with excerpts from our December 2017 Monthly Comments.
BITCOIN: Is it an Investment or a Currency (or both)??
Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low-cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we set out our perspective, then and now, below.
We start by referencing Warren Buffet, who is among the best, if not the best, investor of our time, and one of the world’s richest people. A December 2017 article from WealthAdvisor.com (http://bit.ly/wb1227), quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”).
The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago, they were almost worthless; in December 2017, their value reached $19,000.”
The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”
Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (http://bit.ly/shillerbc), Professor Shiller wrote: “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”
One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (https://nyti.ms/2DsEc97), the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object. Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?
Investment News, a weekly magazine for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (http://bit.ly/inbc124).
We now find that Bitcoin has recently reached a price of $50,000 per unit, so we can at least say that the bubble − if it is one − has lasted an additional three plus years, and is still going strong. Recently, Elon Musk of Tesla, one of the world’s richest people through his share ownership of Tesla, had his company buy $1.5 billion worth of Bitcoin, and announced that the company will accept Bitcoin as payment for its cars. Countering this news, Charles Munger, Buffett’s long-time investment partner, said he “did not know what was worse, Tesla with a $1 trillion market value (price per share times shares outstanding), or Bitcoin at $50,000 (MSNBC, 2/24/21, 3pm and 4pm).” There is also an online summary of a Private Wealth magazine article citing Bill Gates of Microsoft siding with Buffett and Munger. The same article quotes Janet Yellen, now US Treasury Secretary and former Federal Reserve Board Chairperson, “that it is an extremely inefficient way of conducting transactions.” But the article also notes that PayPal, Visa and Mastercard are starting to accept Bitcoin as payment.
Given all this high-level disagreement, we would comment that if Bitcoin, and all other cryptocurrencies, are unable to establish themselves as currencies, it is hard to imagine how a value can be ascribed to the digital coins on their own. Then again, thinking of the many world paper currencies used as a “store of value” whose supply can be increased or decreased at the direction of central bankers, maybe a new self-declared currency system can be developed. What we do know is that the current system (without Bitcoin) does allow for its currencies to be traded, most of the time in a narrow price relationship, one to the other. At this time, we at PPA have no idea what the future holds on this subject, ranging from a huge crash of a price bubble to wider acceptance as a currency with a price attributed to it in relation to various other currencies. We continue to advise against trading these cryptocurrencies, looking to sell at a higher price than the purchase price over a short time frame.
We close with our January 2021 Comments summary: “the outcome of the interplay among the benefits of the vaccine, a potentially stronger economy, a rising budget deficit, Fed interest rate policy, and possible inflation is unknown. Even if we knew the outcome, we are also aware that financial markets act in strangely contrarian ways at certain times (e.g., extensive stock price gains since March 2020, while the Coronavirus continued strong). As always, we suggest maintaining your previously established asset allocations, without trying to guess which assets will outperform others in a given time frame.”