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The bright side of higher rates
Higher interest rates may seem like bad news for consumers and businesses, but recent rate increases —
especially from historically low levels around the world — indicate improving prospects for global growth
and the potential for higher U.S. government spending under a Trump administration.
Deflation fears are quickly receding to the background
%
The long-term trend in interest rates is supported by
economic fundamentals
A steeper yield curve lowers the likelihood of a near-term
recession
Barron’s Best Fund Families, February 2016 edition
%
Deflation fears
are quickly
receding to the
background
• Rising interest rates in the U.S. and other developed economies reflect recent reports of improving
economic health—accelerating growth and rising consumer prices
} Not only have yields on 10-year U.S. Treasury notes increased (up 50 basis points from July lows), but so
have sovereign bond yields in the U.K., Germany and Canada
} Many of the concerns that had stoked global deflation fears (e.g., Brexit, slower growth in the U.S.,
market turmoil in China) have shown to be less worrisome than previously believed
•T
he headline U.S. annual inflation rate for September was reported at 1.5%, the highest level in nearly two
years, while the annualized core inflation rate (less food and energy costs) remained steady at 2.2%
•M
arket-based indicators of inflation expectations are as high as they have been in a year and appear
poised to rise further (see chart below)
Breakeven U.S. Inflation Expectation based on 10-year U.S. Treasury market data
Jan. 1, 2015 through Nov. 7, 2016
2.00%
2.00%
11/7/16
1.72%
1.75%
1.75%
1.50%
1.50%
1.25%
1.25%
2015
2015
Q2
Q2
Q3
Q3
Q4
Q4
2016
2016
Q2
Q2
Q3
Q3
Q4
Q4
Source: Strategas Research Partners
Capital market insights | 2
%
The long-term
trend in interest
rates is supported
by economic
fundamentals
• A supply/demand imbalance in the U.S. government bond market supports a longer-term trend of rising interest rates
} Domestic demand for U.S. Treasuries has leveled off with the end of the Federal Reserve’s bond-buying “quantitative
easing” program (see chart at left below)
} Foreign demand for U.S. Treasuries has dropped dramatically (see chart at right below) as U.S. dollar weakness
relative to the Euro and Yen has made U.S. assets less attractive to international investors
} On the flip side, U.S. Treasury bond supply is expected to increase with Trump’s economic stimulus proposals and an
expanding federal budget deficit
•W
hile these economic conditions should continue to drive the long-term trend of higher interest rates, investors can
expect periods of short-term bond market volatility
U.S. Treasuries held by the Federal Reserve
U.S. Treasuries held by foreign central banks
March 2011 to March 2016
January 2012 to November 2016
$3.0
120%
120%
Total US Treasury holdings $T (left axis)
15%
$3.2
Total US Treasury holdings $T (left axis)
Year-over-year % change (right axis)
Year-over-year % change (right axis)
$3.0
10%
$2.8
5%
$2.6
0%
$2.4
-5%
80%
80%
$2.0
40%
40%
$1.0
0%
0%
2012
2013
2014
Source: Federal Reserve Bank of St. Louis
2015
2016
2012
2013
2014
2015
2016
Source: Federal Reserve Bank of St. Louis
Capital market insights | 3
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• A steepening yield curve — when longer-term interest rates rise more than short-term rates—is normal,
healthy and expected under good economic conditions
A steeper yield
curve lowers the
likelihood of
a near-term
recession
• Every economic recession that has occurred over the last 50 years has always been preceded by an
inversion of the yield curve — when long-term interest rates fall below short-term rates (see chart below)
economy
• U.S.
With
longer-term interest rates moving higher as of late, the likelihood of the U.S. economy falling into
recession appears more remote
The yield curve is pointing to continued expansion
Spread between the 10-year U.S. Treasury yield and the federal funds target rate
Spread
between 10-year U.S. Treasury yield and the federal funds target rate
Percent
The indicator that best
encapsulates the stance of
monetary policy relative to the
state of the economy is the yield
curve, the spread between longand short-term interest rates.
6%
4%
Normal Yield Curve
In fact, the curve has been the
single best leading indicator of
economic performance, as it has
inverted in front of every modern
recession and has steepened
before every recovery.
2%
0%
-2%
The curve has been in a
flattening trend for years
now,
but it Yield
is still
steep by
Inverted
Curve
historical standards. It will
take substantially more Fed
tightening from here for
monetary policy to be truly
restrictive and for this recovery
to be in jeopardy.
-4%
-6%
-8%
1971
1976
1981
1896
1991
1996
2001
2006
2011
2016
Note: Shaded areas depict recessionary periods
Source: Bloomberg
Note: Shaded areas depict recessionary periods
Source: Bloomberg
4th Quarter 2016, Data as of September 30, 2016
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Capital market
insights
|4
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Institute
41
Key takeaways
Interest rates on U.S. government bonds have increased with market expectations of a Federal Reserve rate hike in December.
Rising rates on longer-term bonds reflect optimism about the U.S. economy — growth is accelerating and consumer prices show
signs of increasing following an extended period of sluggish inflation and deflationary concerns. Rising rates would be welcome
news to fixed income investors, who have been starved for yield for several years in the recent low interest rate environment.
• Keep in mind that rising interest rates are not necessarily bad news for bond investors — although bond values decline when
rates rise, income from bond yields has historically contributed more to bonds’ total returns
• Look for opportunities to manage the risk of rising interest rates by diversifying fixed income holdings into areas that may
not be as sensitive to interest rate increases
For more help or information, contact your financial advisor.
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