I have many friends and colleagues who believe that it is only a matter of time before interest rates start rising. They say something like, “Rates can’t stay this low forever.” Well I’m here to say that they are partially right. Interest rates can’t stay down forever, but they can stay low for the foreseeable future. And that is what I think they’ll do. I know my view on interest rates is contrarian to the vast majority of pundits, but I don’t believe it’s based on wishful thinking.
There are three misperceptions about the inevitable increase in treasury rates that on the surface sound perfectly plausible but in reality cannot be justified by current trends or just plain common sense. They are:
1. The inevitable normalization of the federal funds rate will cause bond yields (i.e. treasury rates) to rise. Let’s define what we are talking about. The federal funds rate is the interest rate at which depository institutions lend funds maintained at The Federal Reserve to another depository institution. Federal Reserve Chairwoman Janet Yellen has been hinting, maybe, kind of, sort of slowly raising the federal funds rate by the end of this year.
Assuming she comes through, would raising rates on the short end of the curve mean the long end will follow? It would likely have an impact on short term bond rates (3 to 6 months) but I believe almost no impact on five or ten year treasuries and here’s why: Longer term treasury rates are influenced by the law of supply and demand. In recent years we’ve had runaway budget deficits (a huge supply) that has been met with equal or even greater demand for our treasuries from European and Japanese investors who see treasuries as a safe haven for excess cash.
In recent years, with a 13 to 15 percent annual appreciation of the dollar against the yen and euro respectively, Japanese and Europeans have made excellent returns on investing in our treasuries. Instead of a 2 percent return on their investment they are receiving 15 to 17 percent returns due to the dollar appreciating in comparison to their respective currencies. If you listen very carefully, you will hear a giant sucking sound coming from the U.S. absorbing the excess cash from all those investors around the world wanting our treasuries.
2. The recent downturn in economic activity will give way to improving conditions putting upward pressure on higher bond yields. Many believe that the poor economic performance of the U.S. economy in the first quarter was due to transitory factors (usually blamed on bad weather). As those conditions fade away the economy will strengthen, sparking inflation and causing bond yields to inevitably rise. The evidence for this premise is not compelling. Industrial output for the second quarter is projected to show a decline. It is unlikely that our economy will show significant improvement without healthy industrial output.
At the end of 2014, the Fed was forecasting nominal GDP growth of 4.1% this year compared to 3.7% last year. Since then the Fed has been forced to reduce it 2015 GDP forecast to 2.6% annual growth. In addition, the inflation rate forecast was also lowered by 60 basis points. So instead of an upward pressure on inflation due to an improving economy we are in fact showing downward pressure on inflation due to a significant decline in the U.S. economy in recent months.
3. Recent price surges in healthcare & wages will lead to higher inflation causing treasury rates to rise. It is true that many major insurance companies have recently announced increases of 20 percent or more in their insurance premiums. Isn’t that inflationary? Not really and here’s why: When consumers have a major health event causing large medical bills they reduce their discretionary spending on other big ticket items, such as auto purchases, vacations, etc. This results in leaving overall inflation largely unchanged.
But what about recent labor market news indicating a higher employment rate causing upward pressure on wages? A recent report by the U.S. Government Accountability Office (GAO) indicated there still is a substantial slack in the job market evidenced by the high percentage of part time workers in the workforce who still receive wages at nearly 50 percent less than a steady full time worker.
Bottom line, over the last 12 months inflation, as measured by the CPI, is close to zero. There is absolutely no evidence that we are experiencing even modest inflation at this time.
So stop drinking the Kool-Aid when it comes to the idea that interest rates are going to rise significantly any time soon. I do believe that one day rates will rise but not until the end of the next recession, whenever that is. And when that time comes you better hope that you have refinanced every property you own with modestly leveraged long term fixed rate financing. The longer the better. But that day has not yet come.
Have a need for financing? Call me today to discuss at (503) 614-1808
Source: Hoisington Quarterly Review and Outlook – Second Quarter 2015, Mauldin Economics by John Mauldin, July 22, 2015.