Interest Rates – Where to From Here?
Understanding the dynamics that drive interest rates is critical to understanding the level of current rates, why they have changed in the past, and how they might change in the future. This understanding allows investors and pension sponsors to make informed decisions on how to deploy their bond portfolios and what to expect from their long-term, interest rate-sensitive liabilities. This article examines:
- What are the drivers of short- and longer-term interest rates;
- How those drivers impacted 2018 and 2019 year-to-date interest rates; and,
- What is likely for interest rates for the rest of 2019 and 2020?
Based on current expectations on the Fed Funds Rate and expectation for future economic growth, it is unlikely that we will see long-term rates move significantly out of the range they’ve been in over the last several years. For investors and pension sponsors waiting for long-term rates to rise, the wait could be long.
Short-Term Interest Rates:
The main driver of short-term interest rates occurs through the Federal Open Market Committee’s (“FOMC”) setting of the Fed Funds Rate. The Fed’s mandate from Congress is to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” Stated differently, the Fed has a dual mandate of achieving full employment while controlling the level of inflation. The Fed’s main tool for accomplishing its objectives is through controlling the level of the Fed Funds Rate.
In reaction to the 2008 Financial Crisis, the Fed provided liquidity by reducing the Fed Funds Rate to a range of 0.25% to 0.50% and by providing further support via Quantitative Easing (i.e. buying securities to support liquidity in capital markets). As the economy and employment improved, the Fed began to slowly raise rates increasing the Funds rate by 25 basis points (bps) in 2015 as well as in 2016. In 2017, the Fed began to more aggressively reduce their accommodations. They announced the reduction of their roughly $4.5 trillion balance sheet and began to more aggressively raise the Fed Funds Rate. The Fed has raised rates seven times since 2017, with their last increase in December of 2018.
Fed Interest Rate Changes Since 2015
|Date||Rate Change (bps)||Level %|
|12/20/2018||25||2.25 - 2.50|
|9/27/2018||25||2.00 - 2.25|
|6/14/2018||25||1.75 - 2.00|
|3/22/2018||25||1.50 - 1.75|
|12/14/2017||25||1.25 - 1.50|
|6/15/2017||25||1.00 - 1.25|
|3/16/2017||25||0.75 - 1.00|
|12/15/2016||25||0.50 - 0.75|
|12/17/2015||25||0.25 - 0.50|
Source: Federal Reserve
The key question on many investor minds at the end of 2018 was when would the Federal Reserve end the tightening cycle. The Fed will likely end the tightening once they feel that they are at or near what is called the “Neutral Rate”. This is the level at which interest rates are neither restrictive nor accommodative for the economy. The Neutral Rate is estimated by economists and changes with economic conditions. It is also can only be truly evaluated in retrospect.
As the chart below illustrates, when the Fed has pushed rates too far beyond neutral, a recession has often followed (shaded periods). This is easy to see in retrospect. The challenge for the Fed is not crossing this line.
Source: Cornerstone Macro
As of May 2019, the Fed Funds Rate sits at 2.25% to 2.50%. Prior to late 2018, market expectations were for the Fed to move towards a Fed Funds Rate of roughly 3.25%, about where the 10-Year Treasury peaked in October 2018.
The Federal Reserve members anonymously publish their individual expectations for future Fed Funds Rate changes. In October 2018, the consensus of Fed members was near 3.00% ranging between 2.25% and 3.50% for 2020. This would have implied 2-3 rate hikes in 2019 and 1-2 additional rate hikes in 2020. However, in Q4 2018, the Fed reversed course and suggested that they may not raise rates in 2019. The change came as a result of reduced expectations in GDP growth and inflation, which could trigger higher unemployment. For 2019, the Fed Funds Rate should remain near its current level (2.25% to 2.50%), unless we see a significant improvement in economic activity.
Long-Term Interest Rates:
“Long term rates” are the yields available on bonds with over 10 years of length. Although shorter rates are important for the economy and tend to get more publicity, it is these longer rates that are more directly relevant to pension plans and other institutional investors who also invest in long duration bonds or against long duration liabilities.
Longer-term rates tend to move with: 1.) economic conditions; 2.) inflation expectations; and 3.) expectations of the Fed Funds Rate over the next several years (plus/minus a Term Premium which we are assuming stays around zero for purposes of this article).
1. Economic conditions:
Historically, the 10-year Treasury has followed nominal GDP, which is the total value of goods and services produced within an economy, unadjusted for inflation (as opposed to the more commonly cited real GDP, which is adjusted for inflation). While Treasuries and nominal GDP don’t always move in lockstep, they do tend to trend in the same direction. Recent measures of nominal GDP have been near 5.5%, while the 10-Year Treasury has recently been between 2.40% – 2.60%. One could argue that interest rates are artificially low (for a variet of reasons) and that there is still some room for higher rates as long as growth persists. The question then becomes what are the expectations for GDP going forward? We will revisit that later in this article.
The chart below shows the 10-year Treasury yield and nominal GDP. If nominal GDP remains stable there is still room to see the yield on the 10-year rise. If, however, nominal GDP growth wanes there could be pressure on rates to move even lower.
2. Inflation Expectations:
There is a strong relationship between long term interest rates and expected inflation. Higher inflation leads to higher nominal interest rates, but with a lag. A strong economy provides many investment opportunities for higher returns, greater demand for goods and services, and thereby necessitating higher bond yield s to attract investors.
Current expectations on breakeven inflation (Nominal Treasuries minus Treasury Inflation Protected Securities or TIPS) implies a long-term inflation level of around 2%, which has been roughly unchanged over the last several years.
3. Expectations for the Fed Funds Rate:
The Fed’s sudden change in their outlook for raising the Fed Funds Rate provides some interesting clues into what might happen with long-term rates over the next year. If the Fed was to raise yields beyond the Neutral Rate, then the yield curve would likely become inverted (i.e. short-term rates exceed longer-term rates). This inversion typically implies that Fed policy has become restrictive and that growth prospects and inflation will likely decline. This gives some color to why the Fed backed off from its original path of rate hikes for 2019. Based on comments from the Fed, we are not likely to see additional rate hikes in 2019, unless future data suggests a strong pickup in economic activity.
Credit spreads, the difference between Treasury yields and corporate bond yields, are largely driven by equity market volatility and default expectations. Higher credit spreads imply a higher probability of default by bond issuing companies. Credit spreads rose significantly at the end of 2018 as fears of a recession, and thus corporate defaults, mounted. A good measure of equity market risk (which tends to correlate highly with credit risk as measured by credit spreads) is the VIX index. The VIX is a volatility index that measures price fluctuations on the S&P 500 index. Historically, if the VIX has a prolonged stay above 20, we tend to see credit spreads rise (i.e. sustained volatility increases credit risk). Credit spreads tend to rise in these high volatility periods as the flight to safe assets drives Treasury rates lower while the rates on their corporate counterparts fall less or even rise. The chart below shows the VIX over the last five years alongside high yield spreads (a measure of credit risk for companies with lower credit quality). You can see the increase in credit spreads in late 2018 corresponding to a sustained VIX above 20.
So far in 2019 the VIX has come back down under 20, which is not surprising given the strong equity market performance so far this year. As a result, credit spreads are moving back towards the low levels that we had seen in 2018.
Pulling it all together:
Given all of the drivers of interest rates, where do we see rates going from here – especially long-term corporate rates?
What we are likely to see from the Fed:
Given market volatility and political uncertainty, the Fed will most likely move cautiously for the rest of 2019. Their original expectation of three additional rate hikes in 2019 has now been curbed. So what is the Fed likely to do? The Fed has said it will be data dependent. It will likely pause through mid-year and reassess a number of economic and political factors.
At this point it is unlikely that we will see any additional rate hikes in 2019 without a significant pickup in inflation and/or real GDP. If economic activity worsens, then we may even see rate cuts towards the end of the year. That leaves us with a Fed Funds level of between 2.00% to 2.75% in 2019, and possibly not that different in 2020. This is roughly in line with current market expectations.
What we are likely to see for longer-term rates:
Longer term rates are a function of: Real Growth (Real GDP), inflation expectations, and expectations of the level of the Fed Funds Rate. There has historically been a secular correlation between Nominal GDP and the US 10-Year Treasury (see chart from earlier section). If we expect long term Treasury yields rates to migrate towards Nominal GDP, then we would expect the 10-Year Treasury rate to move back above 3%, barring a significant slowdown in growth. Nominal GDP has softened from the end of 2018 and is currently around 5%. This softening will likely continue during the first half of 2019, but is expected to pick up during the back half of 2019. We are not expecting a recession in 2019 as fiscal stimulus and jobs still support consumption. If Real GDP is near 2% and inflation expectations are slightly below 2%, then there is capacity for the US 10-Year to move back above 3% (this assumes a Term Premium of near zero – which is beyond the scope of our discussion in this article).
How market conditions might affect the direction of interest rates in 2019 and 2020:
The 10-Year Treasury is currently bouncing around between 2.40% – 2.60%, roughly 65bps to 85bps below the 3.25% high set on October 9th, 2018. Market volatility had risen due to political turmoil, trade uncertainty, and softening global growth but has largely stabilized in 2019. We are most likely to see slowdown in growth with the potential for a modest pick-up in growth in late 2019. As a result, we ultimately expect interest rates to stay range bound for the time being.
What could change the outlook?
There are various factors that could dramatically change the picture on where interest rates go over the next 12 to 18 months. Political risk can introduce an element that is hard to predict, but can have substantial implications for interest rates. For example, repeals to recently enacted corporate tax cuts in the US could cause a retracement in equity markets and a flight to safety that would introduce additional market volatility and could drive interest rates lower.
Short-term interest rates are likely to remain near current levels given the existing economic outlook. At present the market is pricing in no rate hikes in 2019 and the potential for a rate cut depending on the overall economy later this year. The Fed, however, is maintaining a course that is currently holding rates steady at their current levels.
Based on many of the factors we’ve addressed in this article, longer-term rates are most likely to stay within the range they have been in over the last few years. This means for long-term, high quality corporate bond yields, we are looking at a range of anywhere from 3.50% to 4.50% for the near future.
There are many factors that could ultimately change where short and long-term rates go the remainder of 2019 and into 2020. Investors should continue to monitor the economic and geopolitical landscape for factors that could impact the level of interest rates and to allow for timely and informed decisions.
So what should investors and pension plan sponsors do in 2019? These institutional investors will continue to have the difficult decision of deploying their assets in equities or bonds, although using derivatives can make this decision much easier as outcomes can be better controlled. And for pension plans specifically, sponsors should consider potential arbitrage opportunities that may exist as a result of last year’s spike in rates. A lump sum cashout window could be advantageous this year.