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Interest Rate Outlook
Sunday 10, September 2017

MarianP

Interest rate outlook:  why interest rates may not increase to pre-crisis levels in the short term.

 

Many investors are concerned about the impact of higher interest rates on the value of their bonds. This article considers the trajectory of U.S. interest rates and the impact on fixed income securities. We hypothesize that the U.S. interest rates will rise slowly and that fixed income assets still offer value to investors.  Despite 4 increases in the Fed Funds rate over the past 2 years, yields on US Treasuries have declined over the same time period. (At the time of the first rate hike in late 2015, the 10 Year UST yielded roughly 2.3%. As at September 7, 2017 - the yield is 2.04%).  A variety of geopolitical risks combined with strong fund flows (lots of money looking for a home) are helping to drive yields lower. Investors who adopted a “wait and see” attitude missed out on some of the attractive capital gains generated over the past 24 months. 

 

History and trajectory of U.S. interest rates: The U.S. Government debt is broadly viewed as a benchmark of safety across the world.  In mid-2007, the ten year U.S. Government bond yielded approximately 5.3% and U.S. Government Agency notes were yielding above 6%. At the time, these yields seemed punitive to Jamaican investors as local 10 year JMD interest rates were roughly 13% and local GOJ USD debt was yielding roughly 8%. Fast forward to mid July 2017, 5% and 6% yields are associated with “high yield” investments i.e. higher risk credits. For context, 10 year Government of Jamaica debt (Rated B by S&P and considered high risk) is currently yielding 4.5% while 10 year US Government debt is trading at roughly 2.04% at the time of writing. Looking forward, the Federal Reserve projects that its long run benchmark rate will be 3% post policy normalization. This is notably lower than the peak benchmark rate of 5.25% during the previous economic cycle (post 2001 to early 2007). It’s possible that the aggressive use of unconventional monetary policy in the U.S. and Europe has reduced the long run equilibrium interest rate set by the Federal Reserve.

 

 What is unconventional monetary policy: These policies were implemented by Central Banks in the US, Europe and Japan in an attempt to stimulate their economies post 2008.   These policies included “Quantitative easing” i.e.  purchases of large quantities long-term government bonds even after short-term rates were reduced to zero.   “Forward guidance” - the commitment to keep policy rates at zero for longer than economic fundamentals justified - which further reduced shorter-term interest rates.  Credit Easing, the purchase of private or semi-private assets such as mortgage- and asset-backed securities, corporate bonds, etc. This exercise aimed to reduce private credit spreads and increase the price of riskier assets – in an attempt to increase the extension of private credit.  Lastly, unsterilized currency market interventions helped to devalue currencies and eventually boost exports. These policies did indeed reduce long- and medium-term interest rates on government securities and mortgage bonds. They also narrowed credit spreads on private assets, boosted the stock market, weakened the currency, and reduced real interest rates.  

 

Why it is relevant: With a wide array of different tools to implement monetary policy, Central Banks may not have to increase interest rates to pre-crisis levels in order to control inflation.   Additionally, contrary to conventional economic theory, rising interest rates in the U.S. have not caused a massive sell off in bond markets. Rather bond and equity markets have rallied in tandem. It’s worth noting that despite modest economic growth and falling unemployment in advanced economies, inflation remains stubbornly low - further substantiating the case that lower interest rates may be inherent to our new environment.  As a result, investors should focus on securing modest yields on securities of sound credit quality as the low interest rate environment is likely to persist. 

 

 

Marian Ross is an Assistant Vice President of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback:  If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

 

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