A Surprising Forecast on Interest Rates

When the fixed income benchmark yield on 10-year Treasury notes jumped to  3% at the end of 2013, forecasters postulated that interest rates would continue to rise. Since bond values move inversely to bond yields, conventional wisdom indicated an exit from bonds and bond funds. Instead, interest rates fell back. Fixed income has fared well, and some well-informed observers think yields can go lower. What gives?

  Facing the financial crisis of 2008, the U.S. Federal Reserve Bank reduced the federal funds rate to a historically low rate of 0-0.25%, referred to as a “zero interest rate policy.” The “fed funds rate” is the rate that banks charge other banks on balances lent to each other, thereby driving other key interest rates that impact consumers. The fed funds rate influences the interest rates paid on checking and money market accounts, savings, and CDs. Low rates mean rock-bottom interest rates paid to safety-conscious investors.

  Low rates benefit borrowers, except that lending is at low levels. Consumers continue to “deleverage,” shedding debt. RealtyTrac reported that nationwide 43% of  home sales were all-cash purchases, the highest percentage since 2011 when tracking of cash sales began. In many cases, lenders require 20% down, figures beyond the capability of many GenX families. The Millennials are loaded with college debt, jobs are scarce, and big down payments are a non-starter. Large corporations are flush with cash; many do not need to borrow.

 The fed funds rate has less impact on longer term bonds. Inflation expectations and guessing games about when the Fed will raise rates play a greater role in pricing. A fixed income stream becomes less valuable as rising prices impact buying power while rising rates erode bond values. Currently the Fed is pledging to keep rates low and overall inflation is subdued, here and in Europe. Deflation has plagued Japan.

  You ask how inflation can be low when food and gas prices have been rising? First, there is little pressure on wages given a paucity of jobs, and there are no production bottlenecks. Technology means smarter consumers, restraining sellers from hiking prices. But people, employed and unemployed, eat and drive cars, keeping demand for food and energy high. Geopolitical risks in Nigeria, Middle East, and Venezuela are contributing to oil prices above $100 a barrel. Russian meddling in Ukraine and Chinese muscle-flexing in the South  China Sea exacerbates nervousness.

  On June 5, 2014, the European Central Bank (ECB) took the zero interest rate policy one better, introducing negative interest rates. In a bid to stimulate bank lending and raise the rate of inflation, banks must now pay the ECB interest on their deposits and excess reserves. In a talk before financial professionals at a meeting on June 6, sponsored by Pershing LLC, a BNYMellon company, Steven McClurg of Guggenheim Investments indicated that falling eurozone interest rates make U.S. Treasury paper and other American investments more attractive. As demand for Treasuries jumps, prices rise and yields fall in an inverse relationship.

  McClurg also noted that large pension funds are getting closer to full funding and they are taking risk off the table by increasing bond purchases. Insurance companies are matching liabilities with assets, buying bonds across the yield curve out to 30 years. All of this serves to constrain and even decrease interest rates. McClurg sees rates on 10-year Treasury bonds at 2%-2.25% at year end, compared to a current yield at 2.597% on June 6.

 Tom Nelson, Chief Investment Officer, Reich & Tang Asset Management, agrees with McClurg. There is “a lot of cash coming into the U.S. markets.” Said Nelson, “U.S. fixed income is the best looking pig on the global farm.” Lipstick, anyone?

  For the time being, bond buyers do not seem worried about Fed tapering, pulling back on bond purchases. Traders do not see tapering as pressuring interest rates for the time being, although we can expect a market reaction when the Fed starts to actually hike rates.

  Investors seeking yield will continue to look elsewhere, investing in energy, real estate, private equity, and traded equity plays with respectable dividends. Pressure may be off of bonds for now but any fixed income strategy must consider that ultimately interest rates will rise, albeit in measured steps as far as we can see.

 Walker Capital Management, LLC, Lewis Walker is President of Walker Capital Management, LLC.  Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC.  lewisw@theinvestmentcoach.com