To begin, let’s discuss what drives interest rates, both short and long term. Short-term rates are controlled by the Fed, which manipulates such rates via its setting of the Fed Funds target during Open Market operations. The Fed lowers the Fed Funds rate in order to stimulate economic growth when the economy is weakening, and raises it to slow growth when the economy appears to be overheating. Their mandate is twofold — full employment and price stability, which currently is deemed to be a core inflation target of 2%. Longer term rates, e.g., the 10-year U.S. Treasury yield, are a function of investor sentiment and move based on expectations for economic growth and longer term inflation. Long-term rates can also be impacted by technical factors (aka the term premium), such as supply and demand for long-term bonds, and the yields on comparable debt issued in other markets.
Interest rates began their descent to current levels when the Fed cut the Fed Funds rate to near zero in late 2008 in order to provide stimulus to the economy following the Financial Crisis. Within a matter of months, the Fed also began to institute its Quantitative Easing (QE) programs, which involves buying longer term bonds in order to lower interest rates on the long end of the curve, and provide liquidity to the markets. As a result, rates became anchored at historically low levels for several years. Then, in mid-2013, Fed chairman Ben Bernanke announced that the Fed would begin to taper its purchases of bonds, as the Fed deemed that the economy was on the path to sustainable recovery. As a result, the 10-year Treasury yield rose sharply and continued to move higher, closing out the year at just above 3.0%. However, fears about global growth, exacerbated by plummeting oil prices, led investors to seek the safety of U.S. Treasuries during the second half of 2014, causing the yield to fall back to roughly 2.0% by year end. The downward pressure on long-term rates was subsequently compounded by the European Central Bank’s (ECB) announcement in January of 2015 of a very aggressive QE program of its own, which caused European sovereign debt yields to fall to unprecedented levels. This led global bond investors to increase their demand for U.S. Treasuries, given the higher yields available in such bonds relative to European bonds, and put further downward pressure on U.S. long-term yields. Fears of a worldwide deflation contagion also contributed to the low level of bond yields across the globe over the recent past.
Source: Cornerstone Macro
10-Year U.S. Treasury Yields
This brings us to the present. Since the end of April 2015, the yield on the 10-year Treasury has risen by 0.40% to as high as 2.30% (see chart at left). This is a meaningful increase, especially when you consider that the yield was as low as 1.64% in late January of this year. A number of factors can account for the recent rise, including a strong April jobs report, the jump in oil prices, higher core inflation and signs of an improving economic outlook in Europe (see chart below).
Source: Cornerstone Macro
Eurozone Production Mangers Index
Ultimately, the main takeaway from this data is that economic growth is improving, in both the U.S. and abroad, and this is the key factor that will push yields higher over time. The past few years have been marked by very low inflation globally, fears of a deflationary spiral and concerns about the slow pace of global growth. With oil prices rebounding, the U.S. job market expanding, Europe on the mend and core inflation (e.g., ex-food and energy) rising (see below), a rise in long-term interest rates can be interpreted as a sign that investors are now more optimistic about the prospects for economic growth. In addition, it is unlikely we will see additional commitments to QE by global central banks to the same degree we have seen in the past few years. This is a key point because the dramatic deployment of QE by central banks in the U.S., Europe and Japan has played a big role in anchoring global yields at the current low level.
Source: Strategas Research Partners
A move higher in core inflation is especially welcome, in that it reduces the odds of a damaging deflationary spiral in the U.S. and can signal an improvement in demand for consumer goods and services. Specifically, the 2.6% annualized rise in core inflation over the past three months (see chart above) is consistent with a healthier economic environment. In addition to gasoline and food prices, which are rising but are not included in core inflation, we have seen price increases for medical services, housing and rent, and used cars. When such increases are accompanied by healthy employment and consumer income (real disposable income is growing at a solid 3.5% annual rate, while wages are poised to rise), this is considered “good” inflation.
The belief that the Fed is on track to begin raising the Fed Funds rate this year has likewise been buoyed by recently released 2nd quarter economic data that signals a rebound from the weak 1st quarter, as well as by comments from Fed members. When short-term rates are expected to rise, it is a sign that the economy is expanding and the Fed expects core inflation to continue to move toward its 2% target, so investors generally price in higher long-term rates as well. In a recent speech, Fed chairperson Janet Yellen confirmed this belief when she said "it will be appropriate at some point this year to take the initial step to raise the Federal Funds rate target and begin normalizing monetary policy." As such, many now expect the Fed to begin raising the target rate at its September meeting.
While some are concerned that higher short-term rates will have a detrimental effect on economic growth and asset valuations, it should be noted that the Fed is likely to be very transparent and cautious as it raises the Fed Funds rate. The last thing chairperson Yellen wants to do is choke off the still fragile expansion occurring in the U.S. Even after the Fed does begin the process, rates should remain historically low and very accommodative for several years. Also, we can take comfort in the fact that monetary policy tightening has already begun, with the termination of the Fed's QE program last October, and this event has not resulted in a dramatic spike in rates or in a damaging impact to the economy or financial markets.
Importantly, comments from the Fed indicating a “stay the course” approach, combined with economic data showing a rebound from the weak 1st quarter and the move higher in the 10-year Treasury yield, are signaling that the economy is expanding at a rate that will result in more visible growth and normalized yields. It also indicates that we may be finally entering a period where the economy can grow on its own without aid from the Fed. Despite the potential for capital markets' volatility resulting from rising interest rates, this is ultimately good news in that it paves the way for a more normal economic environment. Such a development would be very welcome given the uncertainty that has plagued markets over the past six years.
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