Some strategists have argued that we are in a long-term period of low interest rates. The Fed has an incentive to keep interest rates near zero indefinitely. Unemployment and underemployment rates exceed historical norms. The national debt will keep the United States as a net borrower and gives the government reason to minimize its cost of borrowing. The pundits that have been calling for rising interest rates have erred for two years running. The predictions have been dead wrong. Interest rates have declined, not risen. Aren’t we in a new paradigm of permanently low interest rates? Don’t believe it.
The long-term direction of interest rates is up. The current interest rates for the 10-year Treasury and the 30-year Treasury are 2.37% and 3.12%, down approximately 65 basis points and 85 basis points from 3.02% and 3.97% on January 1st. The interest rates of the 5-year Treasury and short Treasury issues have changed little. The temporary declines in long-term interest rates have resulted from a change in perception, partly because of a harsh winter, which caused a seasonal drop in GDP. At the beginning of the year investors feared that the Federal Reserve would raise the Fed Funds rate in early 2015. The consensus expectation has now moved into the third quarter of 2015. The question is not whether interest rates will rise, but when.
Interest rate forecasts from major investment banks all indicate rising interest rates in 2015 and beyond. Economists surveyed by Bloomberg project the 10-year Treasury will reach 3.46% by the fourth quarter of 2015. Strategists at other investment banks agree. In August economists at Nomura and Barclays both predicted a rate increase by June 2015. Their colleagues at Merrill Lynch cited a similar time frame.
A naive forecast would expect the yield on the 10-year Treasury to at least remain close to 3.46%, if not significantly exceed it, in 2016 and beyond. The reason is that interest rates follow long-term, 25-year to 35-year cycles. We have been in a period of declining interest rates since 1981. Between 1946 and 1981 the yield on the 10-year Treasury rose from 2% to 15%. Between 1920 and 1946 the yield declined from 5% to 2%. As we seem to be at the end of a long-term period of low interest rates, it would be logical to expect interest rates to increase over the next ten years or so.
Within these long-term cycles the Fed manages interest rate policy over the shorter-term economic cycle. The boom-to-bust cycle usually lasts five to seven years. This present recovery is longer than most because of the depth of the 2008-2009 recession and the weakness of the ensuing expansion. Now the economy is finding its legs with GDP growth of4.2% in the second quarter. Once it starts to hike interest rates, the Fed is likely to continue to increase them. This pattern has prevailed throughout its history. No examples exist where the Fed increased interest rates only one time. The probable scenario is for the Fed to increase interest rates for two years or more. Economic necessity requires the Fed to manage inflation and to prevent labor markets and the economy from overheating. The impetus for the Fed to change course from its current zero interest rate policy to a non-zero policy would be a realization that stimulative monetary policy no longer serves the interests of the economy.
After six years of expansion we are close to that inflection point. Forecasts of economic growth and inflation suggest that the Fed will need to be wary. Consensus forecasts show an expanding economy and rising inflation. Economists at Barclays and BNP Paribas forecast that GDP will increase from 2.0% in 2014 to 2.7% and 2.8% respectively in 2015. The median forecasts of GDP growth among 78 economists in a Bloomberg survey are 3.0% in 2015 and 2.9% in 2016. Inflation is likely to increase too. Barclays forecasts the CPI will rise from 1.9% in 2014 to 2.1% in 2015. A strengthening economy and higher costs will put pressure on the Fed to act sooner rather than later.
According to most economists, the recent meeting of the Fed in Jackson Hole marked a turning point in Fed policy. Although her comments were balanced, Janet Yellen’s speech indicated a shift toward policy normalization, an end of the low volatility policy framework, and an emphasis on data dependence. In short, if the economy expands, as most economists expect, the Fed will raise interest rates. The speech also suggests that markets should see increasing volatility in interest rates as the risk of a Fed hike has moved forward in time.
Treasury yields over two-years out have already widened by 10 to 15 basis points in September. I would expect the yield on the 10-year Treasury to keep increasing from now on. Given the recent GDP numbers, the speed at which interest rates will change could surprise people. I could easily envision the 10-year Treasury exceeding 4% by late 2015 and 5% by mid 2016. We have just begun a long, upward march that will continue for the next few years.
What do higher interest rates mean for high yield bonds? Overall, higher interest rates will cause some erosion in value. The effect will depend on what happens to the credit spread – the interest paid to investors for assuming credit risk. If the credit spread narrows, the overall effect may be slight. If it widens, the market could be hit with a double whammy. Historically, the credit spread has narrowed when real interest rates have gone up. This time could be different. Investors in Merrill Lynch’s September 15th Credit Survey expect credit spreads to widen over the next 12 months. That should put pressure on high yield.
Even so, high yield offers a safe harbor versus other fixed income assets. It yields more and reacts less to interest rate movements. Some sectors, however, offer better protection than others. As with investment grade, longer-duration high yield bonds are the most vulnerable. Lower quality bonds are also less interest sensitive than higher quality bonds so that “B” bonds should outperform “BB” bonds. Default rates and inflation should remain muted for the next year or two. The best bet is to target short-duration, lower quality high yield bonds. This sector should remain relatively immune whatever happens to interest rates.
Thomas P. Krasner, CFA - Principal and Portfolio Manager at Concise Capital Management, LP