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.

Chart #1

Chart #1 shows that the ISM survey of the manufacturing sector has done a pretty good job of tracking growth in the overall economy. Current survey levels are consistent with GDP growth of at least 4-5% in the current quarter. If this sort of growth persists for a few more quarters, the US economy will have left behind the "new normal" rate of growth of 2 - 2.5% that prevailed for the first 8 years of the current business cycle expansion. A return to more normal 3% growth trend (and quite possibly higher) seems almost assured at this point.

Importantly, we are now on the cusp of having hard evidence that the Keynesian "stimulus" policies championed by Obama are inferior to the supply-side stimulus policies championed by Trump. Thanks to lower tax rates and reduced regulatory burdens, the private sector is blossoming, investing, and working harder.

Chart #2

Chart #2 shows the ISM survey of service sector business activity. It's been volatile of late, but the September released was a blockbuster. It's safe to say that business activity in the service sector (by far the largest sector of the economy, generating about 70% of total jobs) is picking up meaningfully.

Chart #3

Chart #3 shows that the hiring plans for businesses in the service sector are robust—September's number was the strongest on record.

Chart #4

Chart #4 compares the service sectors in the U.S. and the Eurozone. The Eurozone continues to lag conditions here, especially over the past year. That is likely the result of our tax cuts, strong corporate profits, a pickup in business investment, and sharply reduced regulatory burdens. In short, Trumponomics appears to be working, and in a big way. The Eurozone still suffers from "eurosclerosis."

Chart #5

Chart #5 shows how real yields on 5-yr TIPS (Treasury Inflation-Protected Securities) tend to track the growth trend of real GDP. If GDP growth reaches 4% or so on a sustained basis, this chart suggests that real yields could rise significantly from current levels. Nominal yields would not be far behind: a 2.5% real yield on 5-yr TIPS would be consistent, in a 2% inflation world, with 10-yr Treasury yields of 4-5%.  

Chart #6

Chart #6 compares the real and nominal yields on 5-yr Treasuries (blue and red lines), and the difference between the two (green line), which is the market's implied inflation expectation over the next 5 years. Inflation expectations remain anchored around 2%, which is exactly what the Fed is targeting. I worry that the Fed might be slow to raise rates in line with stronger growth expectations (which would allow inflation to pick up), but so far they seem to be doing a good job.

Chart #7

Chart #7 shows the overnight real Fed funds rate (blue) and the real yield on 5-yr TIPS. You can think of these two lines as a measure of the slope of the real yield curve from one day out to 5 years. The time to worry is when the real yield curve becomes inverted (as it did prior to the last two recessions). For now the curve is positively-sloped, and that is normal. The real Fed funds rate is an important variable to track since it is the Fed's true target, and it best reflects how tight or loose monetary policy really is. Real yields are only just beginning to rise from zero. That is consistent with the Fed's stated desire to be relatively "neutral."

Chart #8

Chart #8 compares the slope of the Treasury curve (from 1 to 10 years, shown in red) to the real Fed funds rate (blue). Recessions have always been preceded by a flat or inverted yield curve and very high real short-term yields. We're a long way from there still.

Chart #9

Chart #9 shows Bloomberg's Financial Conditions Index. By this measure financial conditions are pretty much optimal. I note that 2-yr swap spreads are only 16 bps, which means that the market's appetite for risk is strong. 5-yr Credit Default Swap Spreads are around 60 bps, which is about what you would expect in a normal, healthy economy with a supportive financial backdrop.

For the time being, higher interest rates are something to cheer, not fear. (Unless of course you are a bond investor, in which case you need to minimize your duration risk.)