Interesting times for interest rates

As we move through May 2015, U.S. interest rates remain at the low end of their historical range. As of May 20, 2015, the bell-weather 10-year U.S. Treasury bond was yielding near 2.3%, about 0.70% below what it was yielding at the start of 2014.1 This was a real contrast to expectations, given that most economists predicted the improving economy to push rates up, not down. We saw the U.S. economy continue to improve, so why did rates throw a curve ball and go down? And should investors expect them to stay low?

Everyone is watching the Fed.

Much of the media attention on interest rate moves is focused on the Federal Reserve and the actions it may take to tighten (increase) or loosen (decrease) interest rates. The Fed attempts to accomplish this by changing the Federal Funds Rate, or the interest rate paid by high quality financial institutions to borrow and lend money overnight. This is no doubt a very short-term measure of interest rates, but one that receives a lot of attention. The Fed Funds Rate will influence interest rates across the term spectrum, with a greater impact at the shorter end, but it certainly isn’t the only driver of interest rate moves. Other market forces – such as supply and demand – impact interest rates as well. And that’s where much of the story behind interest rate moves (almost 1% drop despite no move in the Fed Funds Rate!) in 2014 lies.

A few factors that drove demand for Treasuries in 2014.

The U.S. remains the safe-harbor for most of the investment world. When concerns arose about slowing global growth, particularly troubles in Europe, money flowed to U.S. Treasuries for safety. For most of the year, the Federal Reserve was still involved in its quantitative easing (QE) program, creating above normal demand for Treasuries. Wall Street, May 12, 2015 Wall Street, May 12, 2015 Investing remains a relative exercise. When compared to some of the other large bond markets in the world, U.S. Treasuries still offer greater return for much less risk for the yield being offered. Consider the yields of some of the major global government bonds above and tell me where you’d want to place your assets.
What can investors expect going forward?
There are some indications that rates will rise in 2015. On the short-end, there is an expectation that the Fed will increase rates some time during the year, based upon the strengthening economy and the desire to stay in front of inflation. The Fed may also impact longer-term rates. Now that it has officially ended its quantitative easing program, there will be less demand for Treasuries from the Fed. In addition, if the economy continues to strengthen (which the Business Cycle Index currently forecasts) and we experience moderate inflation, that could cause the market to push rates up. On the flip side, continued concerns about Europe could leave the U.S. as the safe haven of choice, keeping demand up and rates low. Japan and Europe are also in the midst of implementing their own versions of QE, which is expected to lower their respective interest rates. If that holds true, U.S. yields should remain attractive to investors around the globe.

The bottom line

It’s unlikely we’ll see a repeat performance of 2014 this year when it comes to 10-year U.S. Treasury yields.It’s more likely that rates may rise if the U.S. economy continues to improve at its current pace. However, that was the strong consensus last year and it proved to be very wrong. We shouldn’t be surprised if rates move up, down, or sideways this year. But no matter in which direction rates move, help your clients avoid repositioning their portfolios based upon an interest rate call, unless they are prepared to suffer the consequences of a wrong call. Share an end investor approved version of this article via the March 2015 edition of Consider this.
1 U.S. Department of the Treasury Resource Center. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide.