Download What if Interest Rates Rise? A Special Commentary Series

Wh at i f I n t e r e s t R at e s R i s e ?
A Special Commentary Series
what causes interest rates to rise?
There’s no disputing that interest rates remain near
historically low levels. Our economic forecasts suggest
that rates will remain generally low for some time to
come, but we do acknowledge there’s considerable
risk that in the future interest rates will rise. It’s our
philosophy, however, that financial markets don’t move
without reason; in other words, being concerned that
interest rates will rise simply because they’re at historical
lows isn’t a valid argument. Instead of focusing on an
assumption of higher rates that’s been wrong for several
years now, we believe it’s more valuable to identify the
reasons that interest rates could rise in the coming
months and years.
Inflation
Inflation, or really inflation expectations, are a key part
of longer-term interest rates in that that $1 today isn’t
necessarily worth $1 in 10 years. As prices in an economy
rise, a future payment (e.g., a bond maturity payment)
becomes less valuable. As such, investors need to be
compensated for the fact that their purchasing power
naturally declines over time. If the markets expect
inflation in the future, interest rates encompass that
expectation, and changes in these inflation expectations
(Chart A) will trigger changes in interest rates. One
major trigger of higher inflation expectations is stronger
economic growth; it’s mainly through this handle that a
stronger economy can cause higher interest rates.
Chart A: Inflation Expectations
5-Year Inflation Expectations
Percent
3
10-Year Inflation Expectations
Expectations of Higher Inflation Are One Reason Rates Could Rise
2
1
Supply
The volume of issuance in the overall bond markets
has a clear long-term influence on interest rates—more
supply leads to higher rates. While Treasury supply has
been increasing at a rapid clip as the government looks
to fund budget deficits, the supply in many other areas
of markets has actually been contracting. As a result,
the amount of outstanding bond market supply has
increased at an average of 3.4% per year over the last
five years, compared to 9.9% per year in the prior five
years1. Given shifts in the U.S. economy, it seems likely
that non-Treasury supply will continue to grow slowly, as
sluggish economic conditions aren’t conducive to bond
market borrowing. Much higher supply could push real
interest rates higher, but that doesn’t seem to be an
imminent concern for the markets.
Demand
Investor demand for bonds is another determinant
of interest rates, and is also one of the more oftdiscussed risks to the markets at present. Returns
on fixed income investments have benefitted from a
decades-long decline in interest rates, and investors
have increased their allocations to the bond markets
along with these returns. With interest rates near
historic lows, one concern in the markets is the
idea of a so-called “Great Rotation” out of bonds
into stocks. Investor selling of bonds would be one
reason interest rates could rise, though we’d point
out that many institutional fixed income investors
such as pension funds, insurance companies, and
banks are required to invest their liabilities in cash
or fixed income instruments. By our estimate, 45% of
all bonds held by U.S. investors are owned by buyers
who cannot rotate into other market sectors2. That
said, the potential for individuals and mutual funds to
reduce demand for bonds is significant, and is one of
the reasons interest rates could rise.
0
–1
1/08
6/08
1/09
6/09
1/10
6/10
1/11
6/11
1/12
6/12
(Source: Janney)
WWW. JANNEY.COM • © 2013, JANNEY MONTGOMERY SCOTT LLC
MEMBER: NYSE, FINRA, SIPC • REF. 1302456 • WHAT CAUSES INTEREST RATES TO RISE? • PAGE 1
1/13
1 Source: SIFMA as of 3Q 2012. Calculations are based on estimated
4Q 2012 data.
2 Source: Federal Reserve Flow of Funds Z.1 Release as of
September 30, 2012.
Credit Quality
Just like corporations or individuals, nations (in this
case, the U.S.) can only support so much debt for a
given level of income. The U.S. government has been
running deficits for a number of years now, and there’s
a loud debate as to whether current measures to reduce
the deficit will be effective in restoring balance. If
Congress is unable to adjust that balance over time,
the markets will begin to demand higher interest rates
to compensate for the risks the deficits are creating.
While a default by the U.S. government is very unlikely,
it’s conceivable that, over time, Congress could look
to “print” their way out of debt by issuing more dollar
bills. Were this to occur in theory, inflation expectations
would rise and trigger an increase in interest rates.
The good news is that when it comes to the U.S.’ credit
quality and interest rates, studies indicate that there’s a
lot of leeway as to how much debt a country can issue
before its interest rates rise meaningfully.
Federal Reserve
Basis Points
Chart B: Federal Reserve Balance Sheet
Fed Balance Sheet
Trillions of $ U.S.
Fed MBS Holdings
Fed Treasury Holdings
The Fed Owns $1.0tln of MBS and $1.7tln of Treasuries
3.0
2.5
2.0
1.5
1.0
0.5
0
1/08
6/08
1/09
Chart C: Changes in 10yr Rates Around Fed Bond Buying
100
We have thus far avoided discussion of the Federal
Reserve’s (Fed) ability to cause interest rates to rise. This
is not an oversight; rather it’s an acknowledgement that
the Fed’s influence in the fixed income markets is both
unprecedented and somewhat opaque. Starting in the
latter days of the 2008 financial crisis, the Fed began
purchasing Treasuries, Agencies, and Mortgage-Backed
Securities (MBS) to support the financial system. Under
the leadership of Ben Bernanke, these policies continued
with further rounds of purchases begun in 2010 and
2012. As of February 2013, the Fed’s balance sheet (Chart
B)was just larger than $3.0 trillion, most of that amount
invested in Treasuries and MBS. The Federal Reserve’s
goal in adding these securities was to keep interest rates
low by increasing bond market demand, to increase long
run inflation expectations back to the 2% range from
below that level, and to encourage investor risk taking.
3.5
By purchasing bonds, the Fed is increasing demand
in the bond markets, but it is also pushing inflation
expectations higher, which has a mixed impact on
interest rates. It’s an irony of Fed policy that each
time the Fed has announced a round of bond buying,
interest rates have actually increased (Chart C)! At
some point, the Fed will reduce or stop the rate of bond
purchases and might consider selling some of their
holdings. Doing either would likely cause an increase
in real interest rates, but would also reduce inflation
expectations slightly, meaning that, while interest
rates would likely rise when the Fed stops buying, the
increases would be muted somewhat. Keep in mind,
also, that the bond markets already have a built-in
assumption that the Fed will, at some point, slow its
bond buying path and, more distantly, act to raise shortterm interest rates.
6/09
1/10
6/10
1/11
6/11
1/12
6/12
(Source: U.S. Federal Reserve)
WWW. JANNEY.COM • © 2013, JANNEY MONTGOMERY SCOTT LLC
MEMBER: NYSE, FINRA, SIPC • REF. 1302456 • WHAT CAUSES INTEREST RATES TO RISE? • PAGE 2
1/13
85 bps
80
60
43 bps
40
16 bps
20
0
11 bps
QE2
Nov 2010
Operation Twist
Sept 2011
Operation Twist Extension
June 2012
QE3
Sept 2012
(Source: Janney)
Conclusions
In conclusion, there are four major triggers that could
cause interest rates to rise: higher inflation expectations,
higher supply, lower demand, or changes in the Fed’s
policy. To some degree, most of these come down to
the potential for stronger economic growth, which
could push inflation expectations upward, encourage
investors to sell bonds to buy stocks, and get the Fed
to stop its bond buying programs earlier than the
markets anticipate. Our forecast is for growth to remain
at around the 2% range in 2013. But the low level of
returns available in the fixed income markets means that
investors are and should be sensitive to the potential for
rising interest rates, which could come via a range of
these fundamental mechanisms.
This report is for informational purposes only and in no event should it be
construed as a solicitation or offer to purchase or sell a security. The information
presented herein is taken from sources believed to be reliable, but not guaranteed
by Janney as to accuracy or completeness. Any issue named or rates mentioned
are used for illustrative purposes only, and may not represent the specific features
or securities available at a given time. For investment advice specific to your
individual situation, or for additional information on this or other topics, please
contact your Janney Financial Consultant and/or your tax or legal advisor.