Catalyst for Jumping Interest Rates?

Because everyone needs cash to rebuild after the hurricanes and the FED ending QE, lowering balance sheet & 2018 increases.

This could be a challenging time for banks.  While the FDIC has done what they could to provide warning about interest rate risk, many banks are going to get clobbered.  They are taking risks going out very long chasing yield on CMO’s, MBS’s and Muni bonds. In this rising interest rate market these long term investments will lose a lot of value.  Banks will have to start paying higher rates to their depositors and their borrowers are locked into lower interest rates.

Risking interest rates have been talked about for years.  So much so that banks and large institutions regard it as “just noise”. Rates have been abnormally low for several years now.   Those who have chased yield taking on more interest rate risk have not been hurt too bad but this could soon all change.  After the election we saw a spike in rates, there was a little pain, but many went back to chasing yield. Many fixed income security institutional investors are like the very active young person who has a steady diet of burgers, fries, and milkshakes. It doesn’t matter what they eat they do not see the evidence of their bad choices… YET.  Some fixed income fund managers have never experienced the pain of rising interest rates just like the teenager who has never dealt with a “dad bod”.   

I own a software development company that focuses on bond market data.  We are constantly looking for the “holy grail” of predicting interest rates.  We are working on some cool stuff and we have some very sophisticated minds, even a few rocket scientist. While we do not have all the answers (yet) I will make an ostensible argument that we are seeing the catalyst rising rates.  

The argument for rising rates, and why you need to be prepared.

Institutional liquidity.  As a fintech company specializing in fixed income data we  look at static liquidity, dynamic liquidity, and a few other liquidity algorithms to determine liquidity.  We are finding that institutions are not buying and have a few liquidity issues. When they do buy they are chasing yield by purchasing longer callable issues and they habitually count on these investments to “get called” for liquidity and these investments are not getting called.  Many portfolio managers go longer on the curve to get more yield because they are being “sold” investments with the highest commissions. It’s just the way it is.  That is what led to our last crisis.  

Supply and Demand Part 1

When you have more sellers than buyers the price goes down.  So how does this relate to interest rates? The fed is “unwinding” their supply and ending QE, which means the 4.5 Trillion ( 1 Trillion is “normal”) in investments they are going to start selling their fixed income securities (bonds).    Insurance companies need to pay for the damages of multiple hurricanes so they are going to start selling their fixed income securities (bonds).  Banks need to provide cash to builders so they are not buying bonds.  School Districts, Cities, Counties, Airports, Highway Departments, Port Authorities, Water, Sewer Districts, and Utility Companies will be spending billions to rebuild infrastructure in many states.  Many will be selling their bonds and notes held in their treasuries and they will not be buying.    

The FED just signaled their selling so the smart money managers will be selling their long term investments now.  With all the selling going on the supply goes up, without the buyers the demand goes down and so do prices of the bonds. Longer term bonds fall faster than shorter term bonds.  When bond prices go down rates go up.

Being perplexed about inflation and employment is one thing but they are forecasted raising rates 3 times next year.   Janet Yellen and some of her colleges struggle to understand inflation.  Just like the calendar makers of long ago struggled to make a perfect calendar by studying how the sun revolved around the earth.   

Supply and Demand Part 2

Rebuilding after multiple hurricanes, the demand for building materials; glass, wood, copper wire, steel, aluminum, plastic, etc goes up. When there is demand and supply shrinks prices go up. Labor costs go up, the cost of borrowing money goes up (interest rates).   

The citrus fruit industry was devastated by hurricane Irma - orange juice is going up.  Low supply increases prices.    

Massive damage from multiple hurricanes means one thing.  The need for hundreds of billions of dollars in cash to rebuild.   Where does that money come from?  Institutions like governments, insurance companies, banks, and corporations to name a few.    When institutions are selling bonds to raise cash they are not buying bonds.   More selling less buying usually equates to more of a supply in the bond market.    More supply less demand means lower bond prices,  and lower bond prices means higher interest rates.  

Combine that with the Fed needing to “unwind” their trillions of dollars in bond purchases over the last 9 years, which adds another seller.   Now we have the cost of money going up with higher interest rates because of that will the country forgo rebuilding Florida, Texas, and other southern states that need rebuilding?   Will they not rebuild our territories in the Caribbean?    

So when the rebuilding happens what happens to the cost of the building materials?  More demand than supply?  The prices start going up on these building materials. Commodities like copper, steel, wood,  and every other thing builders need to produce the building materials are in high demand.          

Many bank portfolio managers are not prepared, and to many Bank CFO’s and Presidents lack the internal controls for proper oversight.  

Banks put a large percentage of their portfolio in local Municipal Bonds and they chase yield which means taking more risk going longer on the curve.    Bottom line, if they buy 10 million in a 20 year muni bond paying 3% and next year 20 year munis are paying 4.5% their 10 million dollars is now worth 7.3 Million.  Ouch!  

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