Doug Drabik, Senior Strategist, and Nick Goetze, Managing Director, share how interest rates are influenced by a set of competing forces.
The bond market has not experienced volatility to the extent that the stock market has in recent months. Instead, it appears to be suspended in a tug of war between competing forces, balancing healthy economic data and uncertainty of the future fiscal landscape.
After an extended period of low interest rates, pundits have inaccurately prophesied a reversal in interest rates for years. However, current economic conditions are revealing valid factors supportive of higher rates. But how high, how quickly, and how robust of a rate movement is probable? It is very much up for debate.
Plenty of headwinds for higher interest rates still exist. If interest rates move too high, too quickly, the economy could promptly halt its healthy pace of growth. High rates will affect borrowing adversely, diminishing business and consumer participation.
Central Bank Intervention
Global central bank intervention comprises over $20 trillion in assets, up from pre-recession levels of $6 trillion in November 2007. This collective sum includes the balance sheets of the four major central banks: the Federal Reserve (Fed), the European Central Bank, the People’s Bank of China, and the Bank of Japan. At the current pace, aggregate balance sheet assets could top $24 trillion by year’s end.
Despite the proclamations of other central banks, the Fed is the only central bank that has stopped open market purchases and is slowly reducing its balance sheet. The importance of these actions cannot be overstated. It is worth noting that the money that the Fed injected into the economy via quantitative easing and open market purchases largely did not fund the production of goods or services rendered. Rather, these sums flowed into the global stock and bond markets, fueling their rise in recent years. Even if other central banks halt their open market purchases, the significant influence of this newly created money persists.
Interest Rate Disparity
In addition, interest rate disparity continues. Five-year government bonds currently yield 0.68% in Italy and -0.02% in Germany, while they fetch 2.61% in the United States. Moreover, many bonds currently carry negative yields. As counterintuitive as it may seem, investors are willing to pay to lend money to governments around the world whereas traditionally investors would receive interest from the borrowers.
For example, the yield on the two-year government bond in Germany is currently -0.58%. In other words, investors pay the German government 0.58% to hold their two-year bonds. The total value of negative-yielding bonds around the world is approximately $8.6 trillion. When investors can achieve a positive 2.61% yield from an economic leader such as the U.S., demand for U.S. government bonds will likely be a noteworthy headwind to rising interest rates.
Finally, an aging population that controls a majority of wealth may prove to be less of a spirited consumer and more of a saver. If interest rates rise, it will encourage a more normalized transition from growth assets to fixed income.
Unsurprisingly, the tailwinds behind higher interest rates have captured both headlines and momentum. However, investors should proceed with caution. Equities move much more on momentum than interest rates and bonds. In terms of economic metrics, inflation remains the central focus (as it has for the past several years).
The Fed has sought to bring inflation to 2% as measured by the Personal Consumption Expenditures Price Index (PCE). The index has been rising slowly, leading to an unbalanced amount of volatility and slightly higher interest rates. However, the most recent release on March 1 came in at 1.5%, still well below the 2% target.
The Fed is attempting to balance full employment with its long-term stable inflation target of 2%. Its belief is that by observing the data and slowly hiking short-term rates (potentially two to three more times in 2018), it can reach this balance without the economy overheating. As inflation has inched up, the market reaction has been clear: if the market believes inflation is trending up, it will drive interest rates higher.
Fed Chairman Powell has pointed to the reversal of a headwind with fiscal policy. The Tax Cuts & Jobs Act has clearly created substantial change. The bill is likely to free up capital for both businesses and individuals. Higher revenues, larger profits, and lower price/earnings ratios are all potential benefits.
Higher revenues may show up in a variety of ways: larger dividend payouts, stock repurchases, plant or equipment improvements, and consumer purchases. More money in reserve (for both individuals and corporations) may translate to additional spending, which in turn may push prices and inflation higher, eventually driving interest rates higher.
Although central bank open market purchasing activity has clearly been a headwind to higher interest rates, the mere suggestion that this policy will change has been enough for some investors to anticipate a directional rate change. The Fed has been much more direct in communicating and executing its strategy of raising short-term rates. The Fed raised short-term rates four times since the beginning of 2017, for a total of six times since December 2015. It is anticipated that it will hike rates two to three more times this year. While these hikes only impact short-term interest rates, rising short-term rates influence overall rate sentiment.
The Fed’s desire to raise interest rates is conflicting with the U.S. government’s desire to encourage economic activity. While this tug of war between the U.S. government and the Fed continues, global interest-rate disparity and global central bank action will continue to exert peripheral influence. As long as these forces continue to clash, interest rates are not likely to be pulled dramatically in either direction. Rather, rates will likely be range bound, albeit in a slightly higher range.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. Past performance may not be indicative of future results. There is no assurance that any investment strategy will be successful. Bond investments are subject to investment risks, including the possible loss of the principal amount invested. The yield curve is a graphic depiction of the relationship between the yield on bonds of the same credit quality but different maturities.