Bond investors are feeling a little shell-shocked after the rise in interest rates in November. Yields across all sectors of the bond market rose and bond prices declined. As an example, 10-year Treasury yields rose over 29% from 1.84% to 2.37% and the Bloomberg Barclays Aggregate Bond Index declined 2.37% in November. While it is easy to point to the election outcome as the sole reason for the rate rally, rates had been drifting higher since July. In order to understand where interest rates go from here, it is helpful to understand the reason they were inching higher before the election and why talk of a change in fiscal policy exacerbated their move.
WHY DO INTEREST RATES CHANGE?
There are several primary reasons that interest rates change from one day, week and month to the next. Those reasons are: fiscal and monetary policy, economic growth and inflation, and credit quality.
Over the last several years, central bankers (and their monetary policy) at the Federal Reserve, European Central Bank and Bank of Japan, have been doing everything they can to keep interest rates low to stimulate lending. In Europe and Japan, they’ve gone so far as to create negative interest rates, penalizing banks for deposits in order to get them to lend money. However, while economic growth is positive it has been extremely modest. In the U.S. real economic growth has averaged 1.5% over the last year while in Europe it has grown by 1.8%. Despite accommodative monetary policy, growth has been disappointing. This has resulted in lower interest rates.
These same central bankers have been asking for help from fiscal policy makers for over two years. The Republican sweep suggests that the Federal Reserve may get what it hoped for.
Governments, like the U.S. federal government have the ability to shape fiscal policy in order to try to stimulate the economy. Their primary tools are taxes, spending and regulation. The Republican platform includes a reduction in personal and corporate taxes, along with potential for increased spending on defense and infrastructure. The Republican party’s November 7 victory suggests that it will significantly alter fiscal policy going forward.
Current estimates for the new fiscal policy suggest that there could be as much as a $156 billion dollar increase in spending due to tax cuts and a $145 billion increase in defense and infrastructure spending in 2017. If this came to fruition, it could add approximately 1.5% to next year’s economic growth rate. And, because inflation has already been rising, albeit below the Fed’s target level of 2%, this faster growth could trigger even more inflation.
Bond investors are reacting to this change in policy as well as the prospect for faster economic growth and inflation.
There are two variables we don’t know today and should watch. First, what will the scale be for tax cuts and spending? Will the corporate tax rate be cut to 15%, 20% or 25%? Will personal taxes be reduced for everyone? How much increased spending will the tea party conservatives allow? We’ll have to wait and see where policy makers end up. Secondly, what will the base economic growth rate be? Will we be adding 1.5% to something like the recent 3rd quarter’s 3.2% growth rate or the 12 month average of 1.5%?
Credit quality is the other factor affecting bond interest rates. This refers to the ability of a bond issuer to repay the principal it has borrowed. As an example, if Ford Motor Company borrows
$1 billion for 10 years, the difference between the yield on the Ford bond and a 10-year Treasury provides some information about how bond investors view the credit quality of Ford. A current Ford 10-year bond has a yield of 4.60%, 2.2% above the 10-year Treasury yield of 2.4% and about .15% more than prior to the election. The movement in this yield difference provides some advance notice on how bond investors view risk taking. When the yield difference increases, investors are becoming more risk averse. Monitoring this spread will provide clues as to how confident bond investors are that the fiscal policy transition is going to provide the benefits sought.
IT’S THE ECONOMY
Interest rates reached all-time record lows back in July. They had been rising before the election, for two primary reasons. The Federal Reserve has been indicating that it is comfortable hiking rates again this year, probably in December. It suggested that this hike was an attempt to normalize conditions for bond yields given stronger economic growth and inflation. In addition, some of the global risks it saw at the beginning of the year seem to have declined. (Remember when oil prices declined to near $25 per barrel and energy export driven emerging market economies saw declines in their currency?) As investors saw faster growth materialize in the third quarter the rate hike seemed more likely and yields rose. The 2-year Treasury, a good proxy for future short-term interest rates rose from near .5% to over .8% before the election. Since then it has risen another .3% as the fiscal policies suggest more Federal Reserve rate hikes in 2017.
The other reason is better growth. U.S. and global economic growth improved during the third quarter. It was mentioned earlier that the U.S. economy grew over 3% during the quarter. That is double the rate of growth over the last twelve months. This acceleration is viewed by bond investors as another reason to believe that the Fed will continue to hike rates.
At this point, the market has priced in the next two rate hikes. It has also priced in a higher inflation rate due to the potential for a significant shift in fiscal policy. The combination of tighter monetary policy and easier fiscal policy may have some offsetting properties so the rate of change in the economic growth and inflation rate remain uncertain for now.
Still with yields significantly higher than their July low, it seems an attractive time to add to fixed income exposure, especially in those bonds with short to intermediate maturities and a yield advantage over Treasuries.
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group’s investment strategy to provide consistent, actionable investment solutions for our clients
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