With Kevin Richards
Sunday, February 01, 2015
IF you like bonds, then the direction of key interest rates is a factor to watch.
About 18 months ago, I wrote in this space about where I expected US interest rates to end up in 2014.
What I wrote back then was “What is true also is that the days of 1-handle benchmark interest rates are over. Where the consensus lies is that yields will remain over 2.50 per cent p.a. on 10-year US Treasury rates and could break the three per cent threshold before year end. This is largely driven by a market response to the likely action of the Fed, which in our view has been largely exaggerated and ignores the trends in inflation and unemployment rates. For the Fed to make a more aggressive move with tapering, the economy would not only have to beat analysts’ expectation on jobs growth, but needs to be roughly twice the current pace of job creation. Expect rates to continue fluctuating within this new band, so aggressively seek out bonds with appropriately risk adjusted returns.”
Let’s start with the upside. The 10 Year US Treasury yield ended 2013 at 3.03 per cent, actually breaking the three per cent threshold as predicted. For the first three quarters of the year I was correct, the rate hovered within the 2.50 per cent to three per cent band and fell once tapering had ended to close the year at 2.17 per cent moving in the opposite direction of where most market analysts, including myself, had expected.
The Fed noises and the release of economic data have not created the expectation that the Fed is likely to raise interest rates anytime soon, forcing analysts to defer their rate hike expectation to as late as second quarter 2015. Who would have thought that in 2015 we would be back to “one-handle” interest rates on US treasuries, while the unemployment rate stands at 5.6 per cent versus 7.5 per cent in July 2013? The 10 Yr yield rallied on Wednesday after the FOMC meeting closing the day at 1.72 per cent or levels not seen since May 2013.
What has largely been driving treasury yields is the constant combing of the Federal Open Market Committee’s (FOMC) language after a meeting to get a clear enough read of where the Fed Governors have their heads. The use of terms such as “moderate” or “solid” have sent analysts into overdrive trying to predict when the Fed is likely to increase Fed funds rate, but everything has to be taken into context.
Economic Growth
The US economy recorded an annualised growth rate of five per cent in the third quarter of 2014, the highest in nearly 11 years and double that recorded two years prior. This has largely been driven by consumption and investment spending increases. This performance seems to have been sufficient enough for the Fed to upgrade its assessment of economic activity from “moderate pace” at the December 2014 meeting to “solid pace” by the January 2015 meeting.
The decline in oil prices has contributed to the boost in personal consumption spending because of the rise in purchasing power. While businesses are also increasing their investments, they may not be doing so at an aggressive pace, but consistent enough for the Fed’s comfort.
The big clincher is in the housing market. Although US housing starts are more than 25 per cent higher than in July 2013 and at the highest level in the last six and a half years, the pace of growth is slow but steadily inching back to pre-crisis levels. You may recall that one of the main objectives of quantitative easing (QE) was to kick-start housing, so the expectation for housing performance is high.
In my view, slow and steady is not sufficient to get a rise in interest rates out of the Fed just yet, especially with moderating trends developing.
Inflation
A little inflation goes a long way to spur business activity, but the Fed’s target inflation rate of two per cent has not been achieved. Annual inflation in the US fell to 0.8 per cent in December 2014 from the previous month of 1.3 per cent — both well below the Fed’s target rate. The decline is largely driven by the fall in energy prices. The Fed in its January statement stated that it expects that the longer-term effect of energy price declines will dissipate along with labour market improvements over time and should tend back towards the target rate.
Global Market
One consideration that has crept into the Fed’s discourse is what it considers “International Developments”. Whereas the Fed had always considered developments in the global economy in weighing its interest rate decisions and other actions, it is interesting to note that they have now included this in their post-meeting statement.
This could be in part supported by the action of several other central banks globally, not least of them the European Central Bank, who began a wide-scale government bond-buying programme similar to the Fed’s previous action in the US.
The Fed would also be taking note of the slowing growth in economies such as China and the impact that a strong US dollar may be having on the global economy. A strong US dollar does not augur well for US exports, especially in the context of weak global aggregate demand.
In summary, the US economy, while peeking at the edge of the forest, is still not out of the woods.
The ever dynamic global environment in which we live brings to the table new considerations that could influence the decision to hike rates.
The slow pace of growth in the housing market coupled with the threat to US exports and the business environment from a strong dollar and weak global economy is sufficient enough to give the Fed pause.
While the Fed’s language is still intimating a rate hike by second quarter 2015, I believe that the hike is likely to happen much later in the year. With all that said, welcome back to the period of one-handle rates. Let’s see how long before it outlives its welcome.
Kevin Richards is Vice President, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm.
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Whither US Interest rates? - The 2015 update
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