Tuesday, December 6, 2016

The outlook for interest rates

10-yr Treasury yields have jumped 100 bps in the past 5 months, 30-yr fixed-rate mortgages are up almost 70 bps since August (to 4.0%), and the bond market is convinced that the Fed will raise short-term interest rates to 0.75% at its meeting next week. A good part of the rise in 10-yr yields since their all-time low back in early July was due to an improvement in the economy's fundamentals (GDP growth in the third quarter was 3.2%, up from 1.4% in the second quarter), whereas a little over half of the rise in yields has occurred since Trump's surprise election victory. A further breakdown of the rise in yields reveals that about half was due to stronger growth expectations (real TIPS yields are up about 50 bps), and half was due to higher inflation expectations (which are now up to 1.9-2.0% for the next 5 and 10 years).

So it would appear that interest rates are well on their way to normalizing, right? Well, not exactly. According to the implied pricing of the Treasury curve, the bond market is expecting only a gradual rise in note and bond yields over the next several years—less, in fact, than what has occurred in the past 5 months. Whether this is reasonable or not is the issue confronting investors today. If rates end up rising by more or by less than the market currently anticipates, that could have a big impact on interest-sensitive sectors such as utilities and real estate, both of which have already been hit by the recent and unexpected rise in rates.

The chart above compares the current level of the Treasury yield curve (blue line), with the bond market's implied forward yields (i.e., the future yield which is implied by current yields) over the next 2 and 3 years. Most of the eventual rise of yields is expected to occur over the next year, with the Fed expected to raise short term rates another two or maybe three times (to at most 1.5%) over the next 12 months. Beyond that, the market sees the Fed's target rate rising to at most 2% by the end of 2019, and possibly 2.25% by the end of 2020. 5-yr Treasury yields are expected to rise from 1.84% currently to 2.6% by the end of next year, and 2.8% by the end of 2019. 10-yr yields are expected to rise from 2.4% currently to 2.7% by the end of next year, and 3.1% by the end of 2019. The market expects that it will take at least 7 years for 10-yr yields to rise by 100 bps from where they stand currently.

Now let's put these rates in context. As the chart above shows, 5-yr Treasury yields not too long ago were as high as 5%, at a time when core CPI inflation was funning at 2.5-3% and real GDP growth was 2.5-3%. If that was "normal," then today's 1.8% 5-yr yields should be almost 200 bps higher, given the current level of core CPI inflation.

The current level of real and nominal 5-yr Treasury yields (see chart above) tell us that the market is expecting CPI inflation to average about 1.9% per year over the next 5 years. It's unusual, to say the least, for nominal 5-yr yields (currently 1.8%) to be less than the expected future inflation rate over the next 5 years. "Normally," nominal 5-yr yields are 1 or 2 percentage points above expected inflation. Inflation expectations seem reasonable (the core CPI has increased almost 2% per year over the past 10 years), but the level of nominal and real yields seems unusually low, despite their recent jump. This suggests that the market is still priced to miserably low growth expectations. Which further suggests that if Trump's economic plan ends up providing the economy with a significant boost, it's fair to say the market will be quite surprised, and yields will move significantly higher.

The charts above show how the recent move up in 10-yr Treasury yields has affected 30-yr fixed mortgage rates, which are up about 70 bps from their recent, all-time lows. Mortgage rates are still very low from an historical perspective. They were much higher when the housing market was booming in the early 2000s.

Even with the recent jumps in interest rates, and the Fed's almost certain hike in short-term rates next week, it appears that interest rates are still very low and not expected to rise much more in coming years. If you believe there is a decent chance that Trump's economic policies could get the economy back on a healthier growth track, then you need to be very worried about further unexpected rises in interest rates.

While higher-than-expected increases in 5- and 10-yr Treasury yields would definitely be bad news for bond investors, they would not necessarily be bad news for interest-sensitive sectors of the economy. That's primarily due to the fact that higher-than-expected interest rates would most likely come hand in hand with stronger-than expected growth and possibly higher-than-expected inflation. The negative impact of higher than expected rates on the real estate market, however, could be substantially mitigated by the positive effects of stronger growth and higher inflation. It's not obvious, in other words, whether real estate investors should be worried about higher interest rates. Ditto for the utility sector, where prices have already discounted further hikes in interest rates, but not a further strengthening of the economy.

The key thing to keep in mind is this: if interest rates rise by more than expected, it will almost surely be because growth and/or inflation prove to be stronger than expected. Higher interest rates aren't a threat to growth, because stronger growth will boost interest rates.


Benjamin Cole said...

Well first, Scott Grannis deserves a medal for bravery for trying to decipher interest rates.

My own pet theory is that there is a global glut of capital, caused by sovereign wealth funds and public pension plans which make savings automatic.

Many nations also require various forms of business insurance, and insurance premiums tend to be invested.

Some demographics going on too, people have to save for retirement regardless of interest rates.

There has also been a 35-year secular trend to lower interest rates and lower inflation globally, to which I attribute central bank tightening.

Have interest rates, at long long long last, finally reached bottom?

I don't know.

McKibbinUSA said...

Watch for interest rates to rise sharply in the next 3-5 years eventually plateauing at around 16-18% by 2023. As an explanation, I believe that Donald Trump will lead the US into a debt default. The Trump administration will begin redeploying our military back to the homeland to deter or defend against foreign attacks from creditor nations seeking retribution by conquest. Homeland military forces will also be used to quell violence in the cities and provide emergency relief to communities enduring hardships. The Trump administration will make good on its promise to establish strong borders via walls and militarization will effectively fend off immigrants and foreign expeditionary forces. Upon default, the dollar will drop sharply against all foreign currencies resulting in sharp declines in imports, but sharp increases in exports. Foreign lenders will turn their backs on the US resulting in savage decreases in government spending, but also a balanced budget. The good news is that a debt default will put the US on a path that will eventually make America great again, perhaps as early as 2050. My advice is to take cover and get ready for the hard times.

steve said...

Prognosticating markets-especially rates may be fun but it is a waste of a thought process and 16-18%! Sheesh! Give me a break already...

Benjamin Cole said...

US Corporate BBB Effective Yield is at 3.85%, compared to 3.89% the previous market day and 4.27% last year. This is lower than the long term average of 5.74%.---Y charts.

I look for yields to fall after William McKibbin's commentary.

Scott Grannis said...

Mr. McKibbin: you have quite the imagination!

Andrew said...

Scott; Thank-you again for the careful analysis.

I sense that you are not entirely convinced that Trump's policies will improve our nations economic growth rate by a significant amount. There are of course many skeptics, some of whom will suggest that the proposed policy changes are more likely to enrich corporations and executives than aid the country as well as lead to a global trade war.

My sense is that there will be much turmoil (and excitement) from all the changes to our tax structure, there may be only limited elements that actually encourage the creation of real jobs. Further more, this is only on the Federal Level and there are also many needed changes on the state level with regard to costs and regulations.

We are after all, operating in a global competition of sorts and I don't see how the US can compete with the likes of China or Mexico unless we adopt a similar cost structure for transfer payments.

Scott Grannis said...

Andrew: I'm not "entirely convinced" but I'm pretty optimistic that Trump is going to do things that are positive for the economy. If he only succeeds in lowering taxes, especially corporate taxes, that would be fantastic. My main concern has to do with his terrible misunderstanding of trade, but I'm hopeful that he won't cause too much trouble on that front.

The Cliff Claven of Finance said...

Mr. Grannis said:
"If he (Trump) only succeeds in lowering taxes, especially corporate taxes, that would be fantastic. My main concern has to do with his terrible misunderstanding of trade, but I'm hopeful that he won't cause too much trouble on that front."

Trump spent a lot more time talking about the balance of trade during the campaign than talking about lowering corporate taxes.

It is wishful thinking to expect Trump to "forget about" eliminating negative balances of trade ... and focus only on reducing corporate taxes.

Both would be bad economics in my opinion.

Corporate tax rates should be competitive with other nations, but don't have to be lower.

They already are competitive.

While the US statutory marginal corporate tax rate is among the highest in the world, that's not what corporations pay.

There are many deductions and exemptions.

Clever companies, such as Apple, game the international tax code system to pay even less than other large companies do.

The result is the EFFECTIVE US MARGINAL CORPORATE TAX RATE for 2015 was already competitive:
US 18.1%
Japan 24.5%
Germany 21.2%
G& excluding US 19.4%

Data Source: US Treasury

The only reason to lower corporate tax rates to 15% is to temporarily boost stock prices, which will mainly benefit the Top 10% of US income earners.

There is no correlation of stock prices with Real GDP growth.

Real GDP growth depends on productivity per hour growth and labor force (total hours worked) growth.

Productivity growth has been very low in recent years.

And labor force growth has been slow, along with population growth.

Increasing the after-tax profit margins of corporations who already have high profit margins will not boost Real GDP growth to historical levels (3% including recessions) ... or benefit the Bottom 90% of Americans who own little or no common stocks.

A 15% corporate tax rate implemented when median stock valuations are setting records, and corporate profit margins are ALREADY above average, will ensure no Republican is ever elected President again ... including in 2020.

Republicans can get away with bailing out corporations when they are failing, but not giving them free gifts when they are doing well.