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Why interest rates will march higher
(Page 2) of 2
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The economists, bankers and markets finally admitted that the likeliest explanation (and the one favored by new Federal Reserve Chairman Ben Bernanke) was that the world was awash in excess savings. With U.S. interest rates higher than those in Europe and Japan, and with the U.S. economy growing faster than any other in the developed world, the United States was attracting a disproportionate share of that global savings glut. In effect, U.S. long-term interest rates were so low and falling, even as the Fed raised short-term rates, because overseas investors wanted our relatively more attractive bonds and were willing to pay more to get them.
Live by the conundrum, die by the conundrum, however. The same forces that in all likelihood kept long-term U.S. interest rates low are now about to push them higher -- even if the Federal Reserve stops raising short-term interest rates at its May 10 meeting. (In fact, especially if the Fed stops raising rates in May.)
The driving forces
Here's why Greenspan's conundrum will push U.S. long-term rates higher for the rest of 2006.- Faster growth overseas: By the end of 2006, there's a good chance that the U.S. economy will be growing more slowly than the average for the global economy. And, shockingly, for the first time in 15 years, the Japanese economy could end the year growing faster than the U.S. economy. This doesn't mean that the U.S. is about to slip into recession. Just that 2006 will witness a shift in relative economic growth. Bernstein Research projects U.S. growth at 2.9% for 2006, still a solid performance, but well below the 3.4% growth of the global economy this year. (In 2005 the U.S. economy grew by 3.5% and the global economy by 3.3%). The European economy will still lag but turn in a much better relative performance with growth of 2.4%, again according to Bernstein Research, up from 1.4% in 2005. And Japan will grow by 3.2%, up from 2.5% in 2005. Investors will tend to send more cash to the faster-growing economies this year, just as they did in 2005. Only the United States financial markets won't be on the receiving end of that preferential cash flow.
- Rising interest rates overseas: Yields in Japan and Europe are marching upward -- and that will keep pushing U.S. yields upwards too. On April 18, the yield on the 10-year Japanese government bond moved up to hit 2% -- for the first time in seven years. Two months ago, the 10-year Japanese government bond yielded just 1.5%. (The Bank of Japan is also currently trying to wring out some of the liquidity it pumped into the Japanese economy in an effort to jump-start growth. Bank of America estimates that about $200 billion in liquidity, much of which would have gone into U.S. Treasury bonds, will be withdrawn from Japanese banks as part of this effort over the next three months.) The European Central Bank is widely expected to raise short-term rates for the euro-zone to 2.75% in June from the current 2.5%. Nobody expects the European Central Bank to stop there because inflation looks like it's showing some life in Europe. The International Monetary Fund recently raised its inflation forecast for the euro-zone countries to 2.1% from 1.8%. Higher rates, even if they remain lower than U.S. rates, makes Japanese and European bonds relatively more attractive in comparison to U.S. Treasury bonds and will force long-term U.S. interest rates higher, if the United States hopes to continue to attract overseas capital.
- A weakening dollar: Higher relative interest rates elsewhere -- and lower relative interest rates in the United States -- will weaken the dollar. A weaker dollar raises the risk in holding dollars and dollar-denominated bonds such as U.S. Treasurys for overseas investors. And they will demand higher interest rates in order to supply the cash to cover the huge U.S. trade deficit -- $804 billion in 2005, or 6.4% of GDP. The financial markets got this connection immediately: On the day that the Dow Industrials rallied by 200 points, the U.S. dollar fell against the euro and the yen. Bernstein Research is projecting a 5% to 7% decline in the dollar against the euro and the yen in 2006. Not huge in itself but enough to add to the pressure on U.S. long-term interest rates.
The data is preliminary, but it already suggests that the prospect of a quick end to Federal Reserve hikes in short-term interest rates and the increase in yields elsewhere has changed global flows of capital. In March, for example, the Japanese, who are by far the largest holders of U.S. Treasury bonds, sold a net $20 billion in foreign bonds and stocks. That's up from net sales of $7 billion in March 2005.
That's a single data point, and I don't want to make too much of it. Investors won't get a reasonably detailed picture of any change in global cash flows until the U.S. Treasury reports its March data on purchases of U.S. stocks and bonds on May 15. The February data, released on April 17, reassured the U.S. financial markets since it showed that net purchases of $87 billion in February were more than enough to cover that month's $66 billion trade deficit.
Investing as rates rise
Let's be clear: I'm not projecting recession, the end of economic growth, 10% interest rates or the collapse of the dollar.
I am projecting gradually climbing U.S. long-term interest rates even if -- or maybe that's especially if -- the U.S. Federal Reserve stops raising short-term interest rates in May or soon thereafter.
Which does suggest an investment strategy. Rising long-term rates and steady short-term rates work to the advantage of lenders such as banks that borrow at the short end of the yield curve and then lend at the long end of the yield curve. The interest-rate scenario I've argued for in this column would work to increase the profits that banks -- those with a history of managing the spread to their advantage, that is -- can earn on the spread between what they pay to borrow (either in the capital markets or from depositors) and what they collect to lend.
With this column, therefore, I'm adding shares of Wilmington Trust (WL, news, msgs) to Jubak's Picks. You'll find more about that buy below.
Updates
Buy Wilmington Trust
The managers at Wilmington Trust (WL, news, msgs) have demonstrated their ability to safely navigate their way through the interest-rate hikes thrown at the banking sector by the Federal Reserve. In 2005, many banks saw their net interest margin squeezed, as the Fed raised short rates (the cost to a bank of raising money) while long interest rates (what the bank can charge borrowers) stayed steady or even declined. But Wilmington Trust was actually able to increase net interest margins by 0.15 percentage points in the fourth quarter of 2005 from the fourth quarter of 2004. That helped the company beat Wall Street earnings estimates for the fourth quarter of 2005 by 6 cents a share. Now that the spread between short and long rates is about to widen (my projection in my April 21 column), I'm counting on the ability of this team to apply their skills to making outsize returns from the new interest-rate environment. Wilmington Trust showed a 36% increase in net income from the fourth quarter of 2004. (The company reported first-quarter 2006 earnings before the open, but after this column was posted, on Apr. 21). But the real growth story comes from the bank's asset-management business for wealthy clients. Assets under management climbed to $40 billion in December 2005, and revenue from the wealth-advisory services unit has climbed at an 11% compounded annual rate since 1995. The stock recently traded at 16 times projected 2006 earnings per share. My target price for these shares is $53 by October 2006. (Full disclosure: I will buy shares of Wilmington Trust for my personal portfolio three days after this column is posted.)
New developments on past columns
3 big threats to Chinas economic miracle
Workers in China's leading manufacturing center are looking at a 23% pay hike. A plan to raise the official minimum wage in Shenzhen from $86 a month to $100 a month is now before officials in the special economic zone outside Hong Kong. The Shenzhen zone already applies a higher minimum wage than the rest of China's Pearl River Delta exporting region, but companies in the economic zone believe they have to raise wages even higher in order to end persistent labor shortages, which have started to trouble many of China's export industries in the last six months. In contrast, on April 20 the U.S. Bureau of Labor Statistics reported that after inflation, the wages of full-time U.S. workers at the median of the wage scale fell 1.3% from the first quarter of 2005 to the first quarter of 2006.
6 winners for tech's hard times
It was bad news, good news in Yahoo! (YHOO, news, msgs)'s Apr. 18 first-quarter earnings report. The bad news? While Yahoo continues to grow its search business -- up 10% in the first quarter -- the company continues to lose market share in the search market to Google (GOOG, news, msgs). The good news? Internet advertising continues to boom. Display advertising grew by 34% from the first quarter of 2005. The net effect is to push off any big improvement in Yahoo's growth into 2007. Margins fell in the quarter, for example, as Yahoo invested in new advertising search software that will close the gap with Google. Yahoo's problem is that its search engine is less efficient at matching users' searches to the ads it displays. The result is that the ads Yahoo props on the Web page that show the search results get less clickthrough than the ads on a Google page. Yahoo's clickthrough may be only half that of Google's, estimates Citigroup. Since advertisers on the Internet pay per click, you can see Yahoo's problem. New search technology is supposed to make the ads Yahoo surfaces more relevant -- but Yahoo will roll out its new search advertising software over the next year, with a full upgrade expected in 2007. I think growth in the online advertising market will keep Yahoo's stock moving ahead in 2006 with the majority of gains coming as the full upgrade to the new software approaches. That will require investors in Yahoo to have patience -- not exactly the trait that I associate with the average investor in Yahoo. As of April 21, I'm keeping my target price at $45 a share by December 2006. (Full disclosure: I own shares of Yahoo.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Yahoo!. He does not own short positions in any stock mentioned in this column.
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