The most common discussion with clients recently has been about interest rates (and bonds) as interest rates have been rising swiftly as of late.

It’s a popular topic because interest rates impact our lives in various ways; rising interest rates causes bond prices to fall, rising interest rates means things purchased with borrowed money cost more (houses / mortgages, autos / auto loans, credit cards, etc…), future cash flows from investments / projects become less valuable, etc… 30-year mortgage rates have doubled to over 5% from 2.5%

On the other hand, rising rates also motivate us to save more as savings vehicles yield more and motivate us to take on less debt / pay down debt faster. When’s the last time we’ve earned any notable interest in our checking and savings accounts? Many young people probably don’t even realize that banks used to pay interest on those checking and savings balances.

Interest rates have been rising recently as inflation has been hot, and the market is front-running the Federal Reserve’s plans to raise interest rates intended to fight inflation.

In fact, the 10-year treasury rate has more than doubled to about 2.8% from 1.2% in about eight months. The 2-year yield has increased to over 2.5% from about 0.2% in the same period. As I mentioned in my commentary from a few days ago, we’re taking advantage by allocating excess cash reserves to 1 and 2-year treasuries as we can finally earn some interest.

The Federal Reserve (the Fed) is in a VERY difficult position. To fight inflation they must tighten monetary policy (raise interest rates, reduce their balance sheet). At the same time, they risk popping the historic asset bubble we find ourselves in.

The question is, how high will the Fed let interest rates go / how much pain will they tolerate before reversing course again like they did in 2018-2019 when tighter monetary policy led to a brief collapse in stocks and frozen credit markets?

The difference between now and 2018, however, is that inflation is much higher today than it was then, which makes their current position so much more difficult. They don’t have the same freedom to reverse and ease policy once again if inflation stays hot. Today inflation is running over 8% while it was just 2%-3% in 2018. So, the Fed’s hand is forced to a point.

The total U.S. government debt is about $30 trillion. Roughly $9 trillion of that matures in the next two years. Obviously, the U.S. government doesn’t have the cash laying around to pay off the debt but must roll it over…in other words, the U.S. government borrows more to pay off the old debt kind of like borrowing from a credit card to pay off an old credit card balance. So, if interest rates are rising the U.S. government’s debt service also rises as it rolls debt in a higher rate environment.

For example, assume the current average interest rate on that $9 trillion coming due is about 0.10%, or about $9 billion of interest, but they must roll it over at a much higher 2%. That’s a 20x increase in the U.S. government’s interest expense on that portion alone to $180 billion of interest from just $9 billion!

Having said all that, I continue to believe inflation could cool a bit on its own as stimulus wanes and supply chains are repaired (see retail inventories chart below), which, if true, could potentially give the Fed some cover. I’m sure Fed Chairman Jerome Powell is praying every night that inflation cools on its own so he’s not forced into this corner for long.

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