Have Interest Rates Finally Begun Their Long-Anticipated Increase?

Many question the secular environment for bonds, in particular if interest rates have finally begun their long-anticipated increase.  Simple math argues that interest rates cannot decline below zero, so by definition rates are more likely to increase than decrease.  But that argument does not necessarily mean rates must rise dramatically or even immediately since rates can stay in a low range for a fairly long time.  This happened in the United States during the late 1940’s to the mid 1950’s.

As with any historical comparisons of the economy or the financial markets, rarely if ever do circumstances replay in a precise manner.  But our assessment that the fundamental drivers of interest rates, economic growth and inflation, are expected to remain below historical trends is the primary reason we believe interest rates could stay relatively low for perhaps a couple more years.

Note that if economic growth was to improve, this situation could drive interest rates higher simply due to more demand for credit which would not be a bad development.  Rising inflation would be the reason for a more sinister rise in interest rates that, depending on the severity, could cause concern for the economy and the financial markets because of the inherent potential to get out of control.

Guessing future interest rates and when they will change is notoriously difficult.  We might be able to get in the ballpark of a range, with the point being to gauge reasonable limits.  In that regard, we perceive that the key 10-year U.S. Treasury rate is likely to stay mostly in a range of 2¼% to 3¾% for at least the next year or two.  For reference, during the time between the flare-up of the Euro crisis in the summer of 2011 and the FOMC meeting in June, the range was about 1½% to 2½%.

Two general ideas support these possible limits.

First, this interest rate crudely tracks nominal GDP, which equals real GDP plus inflation.  The U.S. economy has struggled to maintain real GDP growth around a pace of 2% per year and inflation has generally been below 1½%.  All but the misanthropic would like to see the economy grow faster, and we would not be surprised if future domestic growth were somewhat stronger than the recent past.  However, it would take a great deal of things to go right for real GDP to achieve a CONSISTANT pace much higher than even 2½% and current evidence suggests this is not happening yet.  At the same time, a sluggish economy remains vulnerable to setbacks such as a geo-political incident (which is ALWAYS a risk even in the best of times), a pullback in consumer sentiment, and any number of other developments that could cause economic activity to occur at a very low pace with even occasional negative numbers.

Second and perhaps more importantly, the 10-year U.S. Treasury rate rarely extends beyond 400 basis points (4%) of the Federal Funds Rate, which the Federal Reserve controls and is currently near 0%.  The Fed has explicitly stated they are not likely to raise this metric until specific economic data is attained, which by their own projections may not occur until mid-2015.  Therefore, an environment of slow to moderate growth argues for a lower spread, which could cap the 10-year U.S. Treasury rate around 3½%.

Much has been made about the recent backup in bond yields as a result of the Fed reminding everyone that their asset purchases will not go on forever.  When the 10-year U.S. Treasury rate increased to as much as 3%, many thought this was only the beginning of a long increase in interest rates and a bear market in bonds.  We strongly disagree.

When Ben Bernanke, Chairman of the Federal Reserve, indicated in May the Fed MIGHT dial back the amount of asset purchases by the end of the year IF economic data permits, many people sold bonds all at once which jolted interest rates higher.  In true financial market fashion, many panicked and illiquidity led to a short-term disruption to the supply-demand balance for credit that moved rates even further than otherwise warranted.  And interest rates higher than required by normal demand will naturally retard economic activity.  Consequently, all eyes are on the housing market to see if there is a negative response to higher mortgage rates as an early clue of this possibility.  If most of the traders and investors who were taking excessive risk have moved out of the market, and certainly if economic activity remains slow, interest rates could very well settle down.

Thus, interest rates have simply adjusted to a slightly higher range than before.  In the absence of a systemic shock, we perceive a scenario of a rapid rise into double digits that would decimate the bond market (and very likely the stock market too) is very unlikely.

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