When I addressed my picks for where to invest in 2010, there was a common theme of looking for yield.   The dividend yield provides aging investors with income and over the last 10 years it was the only reason that the S&P 500 had a positive return.  Yield not only provides income, but provides as a backstop when economic growth turns out to be a bit lower than expected.  Within insurance companies, pension funds, endowments, and banks yield is critical.  Insurance companies guarantee rates to their policyholders, banks must earn rates of interest higher than what they provide in savings accounts, pension funds must payout for retiree benefits, and endowments need to fund the operations of colleges and other institutions.  One thing to keep in mind in this market turnaround is that the demand for yield is relatively constant, and low interest rates place these yield hunting institutions in a tight spot.  When interest rates are low and they can no longer find appropriate rates of return on treasury bonds, they turn to riskier assets.  First they start looking at high-grade corporate bonds, then as spreads collapse they continue to look further down in credit quality, and finally when no more options can be found they turn to leverage.

High-Grade Investment Grade Spreads are Running out of Room to Tighten Further

I do still believe that high-grade corporate bonds have further room to tighten, but eventually they will have no where to go.  When corporate bonds start trading at yields that are similar to treasuries (Wal-Mart recently issued at a negative spread to the 5 year treasury) then corporate bonds are over-priced.   In my last post, I argued that the federal reserve will allow long-term interest rates to rise (by stepping away as the marginal buyer).  There were many comments on that post related to whether there would be inflation/deflation, whether China would step away entirely, or whether the fed had any control at all.  China is currently committed to pegging the Renminbi to the US Dollar and I doubt that is going to change substantially until their internal consumer demand makes up for the loss of exports.  That is why I suggested buying emerging markets and shorting US equities, because the falling dollar and pegged Asian currencies will most likely lead to a bubble in Asian asset prices.  As for whether the Fed controls long term interest rates, I know it seems crazy but it does seem that “quantitative easing” works.  It worked for the UK and it seems to have worked for over a year here in the states.  And finally for deflation…the Fed will do *everything* in its power to fight deflation.  It might not have worked in Japan because they were too slow and did not try hard enough, but as long as the Federal Reserve remains autonomous they will succeed.  Deflation would mean an absolute default of the United States and its consumers.

So going back to my argument over rising treasury rates, I do believe that the Federal Reserve will allow them to rise over the next 12 months.  If there is another global economic crisis, then the flight to the dollar will be enough to keep US interest rates low.  Many will argue that the US dollar is “funny money” or trash, but in relation to many other developed countries it is not all that bad.  Circling back to my original point in talking about the demand for yield, what does that mean for treasury rates?  Well, as long as inflation is kept under control (sub 5% annually) and China continues to somewhat peg their currency, then treasury rates can rise and these “yield hunters” will start buying treasuries instead of corporate bonds, preferred stocks, and equities which would keep the rise in long-term treasury rates at a stable growth rate.    If instead, treasury rates are artificially suppressed, then the yield-hunters will turn to junk debt and leverage to find the income they need from their fixed income investments…which would just create another US asset bubble.  The Federal Reserve must act like the maestro of puppeteers to accomplish this goal without falling into spiking inflation and spiking interest rates.

Will there be negative consequences to higher interest rates?  Absolutely, but their should be negative consequences to decades of easy money and reckless borrowing.