Current global economic and demographic trends are pointing to more modest economic growth than what has prevailed in recent decades. For decades, central bankers have combatted demographic changes (slowing birth rates, aging populations, etc.) by easing monetary policy. However, with policy rates near zero in the U.S., EU and Japan, central bankers are low on ammunition. Our suggestion for central bankers is to stop fighting. Demographics trends will dictate growth (along with governmental fiscal policies). The best central bankers can do is to maintain monetary policies which are modestly stimulative to neutral based on demographic trends. This probably means a Fed Funds Rate which peaks at lower levels than it has in the past. The Fed Funds equilibrium rate (the Fed Funds Rate which neither subtracts nor adds to growth) was once thought to be 4.00%. Maybe it is 2.00% to 3.00% this time around. Last year, former Fed Chairman, Ben Bernanke, stated several times that the equilibrium policy rate could be lower this time around.
We concur with Mr. Bernanke. If we were to extrapolate, we might conclude that long-term rates will also peak at lower levels. As economic and interest rate cycles peak, the U.S. Treasury yield curve tends to flatten (or invert). It is our opinion that we could see a situation in which the Fed begins raising the Fed Funds rate beginning mid-2015. Policy tightening should be moderate and gradual. The yield curve should respond similarly as it has during tightenings past. As the Fed raises policy rates, longer-term rates should creep gradually higher. However, at some point, policy reaches equilibrium (between 2.00% to 3.00%), long-term rates stop rising and the yield curve begins to flatten. As the Fed almost always overshoots when it tightens (or eases for that matter), the Fed Funds Rate will probably rise somewhat beyond equilibrium (3.50% is possible). At that point, the U.S. Treasury yield curve could be decidedly flat with both the 10-year note and 30-year bond yielding in the neighborhood of 3.50%. It is because of this scenario that we are willing to extend a bit further out on the curve than many of our fellow strategists. However, there are some caveats.
Rates might not rise as far (or as fast) as we have portrayed if foreign economies (particularly EM economies) continue to stumble or level off at lower rates of growth than they are currently producing. If this happens, the global competition for jobs could heat up with central banks working hard to prevent their currencies from appreciating too much versus those of their trading partners. This could (should) keep rates low. If this scenario plays out, long- term rates might not rise much from current levels.
If emerging nations liberalize their economies, we could see a temporary pickup in growth as their middle classes become more affluent. We say temporary because more affluent middle classes in some countries could push jobs to lower wage areas of the world or jobs could be replaced with technology. The world is flat and there is no shortage in the supply of labor around the world. In this scenario, inflation and growth could reach or exceed trend levels, for a time. The result should be higher interest rates than what we portrayed in our first scenario, but as labor costs rebalance high rate conditions (if we could call a 5.00% 10-year note high) should abate.
We do not see the high rate scenario playing out. Central banks around the world have expressed the desire to do whatever it takes to keep their economies growing. It is the ECB’s commitment to do whatever it takes that is responsible for an Italian 10- year sovereign note yielding 3.20% and a new Greek five-year sovereign note which just priced to yield 4.95% (we can think of better ways to get nearly 5.00%). Range bound labor costs, slower population growth and technological advances promise to keep inflation under control. Although we believe interest rates will move higher during the next two or three years, we don’t see them moving to levels which could be considered high.
Our base case scenario is one in which the U.S. economy grows at between 2.50% and 3.00% and inflation moves toward, but not necessarily through 2.00%. This appears to point to a situation in which borrowing costs creep higher, but revenues grow more slowly (if they grow at all). This scenario would not be good news for high- risk assets, such as deep junk debt (CCC and B) and small-cap speculative stocks. Their relatively weak balance sheets and narrow operating margins leave them vulnerable to rising rates if revenues do not rise similarly. We continue to focus our attention on the upper-tier of the high-yield and lower end of the investment grade corporate bond markets as well as the municipal bond market. There has been much discussion on the Street about which fixed income asset class has the best chance of seeing credit spread tightening in a rising rate environment. In our opinion, no fixed income asset class has a greater potential for spread tightening than municipal bonds.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY