Catastrophe and a secular shift in interest rates

• abnormalreturns
• April 7th, 2010

Ezra Klein in a blog post talked today about how catastrophes can take shape in plain sight.  He mentioned the subprime/credit crisis as historical example but also mentioned more meta-examples like global warming and peak oil.  Both of which have been debated seemingly ad nauseum.

This begs the question:  would a secular rise in interest rates be a catastrophe?*

Before our very eyes it seems like the secular trend in interest rates has turned up for the first time in a few generations.  (For our purposes we are talking about long-term US Treasury rates.)  The Buttonwood blog noted by one measure this secular shift was already under way. At present the 30-year yield is now above the 100-month average which has neatly contained the secular bear market in bond yields.

Source:  Economist.com

The post goes on to note how the role of central banks has changed since the time of Paul Volcker in the early 1980′s:

But fighting inflation has eventually taken second place in central banks’ priorities to rescuing the economy and the financial sector.

The implications of a secular upward shift in interest are nearly too many to list.  The burgeoning federal debt, which Klein mentioned as a potential catastrophe, would become even more onerous in this sort of environment.  We are seeing some of these implications play out today as state and local governments are getting squeezed by the economic recession.  For investors, as well, this would also be a momentous change.

For nearly thirty years long-term interest rates have for the most part done only one thing:  go down.  If that trend has changed it affects nearly every aspect of portfolio management.  For instance, equity valuations would have to reflect higher discount rates and borrowing costs.  Equity-centric investors would soon be faced with competitive yields on fixed income securities.  The list goes on.

As with the subprime crisis, the implications of a catastrophe are oftentimes seen by many only in retrospect.  In the case of long-term interest rates the evidence is on our screens on a daily basis.  While a secular shift in interest rates is by no means assured, it it worth taking the time to think through the implications for your portfolio of just such a change.

*For our purposes we are leaving aside the issue of nominal vs. real interest rates.

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