Last week, we discussed how higher interest rates have been the leading cause of market volatility in recent weeks. However, this week, we want to talk about the benefits of higher rates. For the first time in four years, real yields from bonds are once again providing investors with a rate of return that outpaces inflation. We like to focus on real rates of return because it shows a bond’s actual return by subtracting inflation from a bond’s current yield. On August 18, the 10-year yield was 4.26%, which is above the 3.2% year-over-year inflation rate, according to the CPI report from July. That’s a real yield of 1.1% and a welcome change for bond investors. After four years of negative real yields, bonds are once again providing investors with a rate of return that outpaces the CPI. Bonds are essential to a diversified investment strategy, so we will continue to follow rates closely.
For every receiver of higher interest rates, there is a payer of higher interest rates, and the federal government is the largest payer of interest in the world. A chart shown in this episode reveals the net interest over time versus the 10-year treasury. You will see that the red line, which is interest paid as a percent of government revenue, has spiked up to 14% of revenue in interest payments. That spike has happened in excess, higher in 10-year treasury yields. Why and how is that? It’s because, unlike the American consumer, the US government debt is heavily weighted towards short-term debt. Over 50% of US sovereign debt outstanding is for three years or shorter, and over 30% is less than a year. So, as interest rates have been going up, that directly impacts the US debt much quicker than US consumers. Over 90% of US mortgages have 30-year fixed rates. The US consumer is locked in long-term while the US government is not. As interest rates are spiking, we’re seeing that spike also occur. This really hits the road when debt servicing costs eclipse 14% of US government revenues. That causes the government to tighten its belt, cut spending, and find ways to reduce costs because that leaves less money after interest is paid. Interest paid is the first dollar out, leaving less money for everything else. You’ll probably start seeing a lot of talk of austerity and some tightening of budgets in areas.
A large healthcare component was part of the Inflation Reduction Act that passed over a year ago. The Biden Administration didn’t announce which drugs were built in for price caps when the law passed, and tomorrow, that announcement will be made. The ten drugs will have price caps going forward on what the drug companies can charge. The goal of that is to bring the cost of healthcare down. However, there’s the other side of the coin. Every dollar paid out for prescription drugs goes from somebody to a company. The cost then is incurred by these companies, and that’s not been priced in, so we’re about to see a political silly season. Even though these price controls haven’t even been announced yet, eight cases are already going through the works to challenge them. This will go into political facilities and the courts for the next few years. We’re going to watch this closely because it could have a negative impact of up to 8% a year in annual earnings on these companies, depending on which drugs are announced and what the prices are. This is something big we’re watching. Some of that belt-tightening we’ll likely see.
A popular saying in our industry is, “Housing punches above its weight for the economy.” Housing has done an excellent job of holding up our economy while some other factors have fallen back. We got July’s new home sales report, which was strong again. New single-family home sales increased 4.4%. Year-over-year, sales are up 31.5%, which is a big deal. Sales in July were specifically strong in the Midwest and the West. The median price of a new home sold was about $437,000. With the increase in sales, prices are starting to come down. Prices are down 8.7% from a year ago and down over 12% from last year’s peak. Supply is starting to catch up on the new home side, but we are still facing problems with the increase in interest rates. Assuming a 20% down payment on a new home, with the rise in mortgage rates from this year and last year, that’s a 29% increase in the monthly payment. You’re saving 12% on the home purchase but paying 29% more monthly. We need prices to decrease further. Supply is up 150% for new homes since 2022, which is huge. As you can imagine, the supply of existing homes is relatively light because 90% of people are locked into a 30-year fixed rate mortgage at a 3-4% rate, so not many people are looking to move and start paying 7.5% on mortgage rates.
Fi Plan Partners is an independent investment firm in Birmingham, AL, with a team of professionals serving clients across the nation through financial planning, wealth management and business consulting. The team at Fi Plan Partners creates strategies in the best interest of their clients using fee based investing.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Economic forecasts set forth in this presentation may not develop as predicted.
No strategy can ensure success or protect against a loss. Stock investing involves risk including potential loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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