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Each year for the last few years we've been taking a hard look at the drivers behind interest rates and conveying our thoughts about where they will go in the future. When we last looked at where rates were headed last December, we surmised that without substantial global economic growth that rates wouldn't move higher. Well … they didn't move higher…they moved a lot lower. With the onset of a global pandemic, interest rates went on a wild ride through the first half of 2020. That ride has had far-reaching effects on investors, especially those with interest rate-sensitive liabilities like corporate pension sponsors.

So how has the current economic environment affected interest rates and what could cause them to change course between now and the end of the year? In this article, we'll look at:

• The drivers of short- and longer-term interest rates;
• How those drivers have affected rates year-to-date; and,
• What could cause rates to change for the rest of 2020?

Market background

Treasury rates have fallen sharply since 2018, where the 10-year reached roughly 3.25%.  We began 2020 at approximately 1.50% on the 10-year and have since fallen to all-time lows below 0.60%.  Corporate bond rates started 2020 lower than where they began in 2019 and have fallen further so far in 2020.

With the onset of the global pandemic in March, the Federal Reserve cut the Fed Funds Rate, which is the "overnight" interest rate that banks borrow the Fed at, from 1.50% – 1.75% to 0.00% – 0.25%. This is in line with where interest rates were held from 2009-2015.

Given that the Fed isn't currently interested in taking its Funds Rate negative, at this point there's nowhere left to go but up (hopefully).  However, that won't happen until the economy recovers and is rooted on solid ground.

With the global economic upheaval that began in Q1, the world's major central banks started to infuse cash into the economy via Quantitative Easing ("QE") measures, which involve central banks buying securities such as Treasuries, mortgage-backed bonds, corporate bonds and even in some places, equities. The Fed began its full-scale buying programs in late March and April to "support liquidity and the flow of credit to consumers and businesses." These programs, along with fiscal and monetary programs around the globe, total an unprecedented 30% of Global GDP, year-to-date.

Equity markets have also been on a wild rollercoaster so far in 2020. Q1 proved to be one of the worst quarters in history, while Q2 was one of the best. The volatility in the equity markets (domestic and international), demand for safe haven assets, and the outlook for growth are why we continue to see Treasury rates sitting at or near all-time lows.

Corporate bond yields have also dropped substantially but have been buoyed up somewhat due to widening credit spreads – which is another indicator of the shaky outlook that the market is factoring into current yields. Credit spreads on high-yield bonds have narrowed since their widest levels in late March, but are still pricing in risk that reflect the higher probability of default/bankruptcy.

Short-term interest rates

The main driver of short-term interest rates comes from the Federal Open Market Committee's ("FOMC") setting of the Fed Funds Rate. The Fed's mandate from Congress is to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates." Stated differently, the Fed has a dual mandate of achieving full employment while controlling the level of inflation. The Fed's main tool for accomplishing its objectives is through controlling the level of the Fed Funds Rate.

As mentioned above, the Fed took swift action in March to reduce the Fed Funds Rate to 0.00% – 0.25%, the same level it maintained in the aftermath of the Great Financial Crisis of the late 2000's. While inflation expectations continue to be well below the Fed's target of "at or near 2%," unemployment, however, has touched levels not seen since the Great Depression.

A big question now is whether all those lost jobs will come back at all – we believe that at least several percent of the increase in the unemployment rate will be the result of "permanent" job losses that will take years to recover vs. those jobs that can return more quickly when the direct impact of the pandemic subsides.

Accelerated technology will make some jobs obsolete or change the way that work is done. This re-shaping of the workforce is a common feature of recessions and, while painful, is ultimately healthy.  We will not know for some time which jobs will return quickly and which will be lost permanently, but the Fed will be focused on those permanent job losses and its need to support the economy while it creates new ones.

Unemployment and excess capacity are deflationary forces, and high unemployment combined with deflation or at least "low-flation" will allow the Fed to most likely keep short-term rates low for many years.

What would cause the Fed to change course?  If unemployment declines much more quickly than expected, or if inflation expectations increase significantly and unexpectedly, then the Fed could be forced to raise interest rates.

Long-term interest rates

"Long term rates" are the yields available on  bonds with over 10 years of length.  Although shorter rates are important for the economy and tend to get more publicity, it is these longer rates that are more directly relevant to pension plans and other institutional investors who also invest in longer maturity bonds.

Longer-term US Treasury rates reached historic lows in 2020 with the 10-Year falling below 1.00% in March and bottoming out just over 0.50% shortly thereafter. The 10-Year yield has hovered primarily between 0.60% and 0.80% ever since. The 30-Year also found new lows when it fell just under 1.00% in early March.

Longer-term rates tend to move with the following:

1. Economic conditions;
2. inflation expectations;
3. and expectations of the Fed Funds Rate over the next several years (plus/minus a Term Premium which we are assuming stays around zero for purposes of this article).

For the near term, long Treasury rates should remain range bound, with the yield on 10-year bonds below 1%, given that the Fed is likely to hold short-term rates near zero for several years.

1. Economic conditions. Historically, the 10-year Treasury has followed nominal GDP (nominal GDP is real GDP, which is what is generally reported in the media, plus inflation).  While these don't always move in lockstep, they do tend to trend in the same direction.

Currently, nominal GDP is near 2% (Q1'20), while as of the writing of this article the 10-Year Treasury is at approximately 0.60%.   With near term GDP growth in question, and inflation expected to remain low, it makes the prospect of long-term rates rising substantially in the near-term improbable. As we've seen historically, even with nominal GDP taking a significant plunge, Treasury rates have managed a smoother path that is directionally consistent over time.

What we've seen so far this year was a significant drop in long-term rates.  The question now remains whether they will go lower (even approaching the negative rates we see in Europe and Japan) or stabilize and begin a process of moving higher as long-term nominal GDP growth prospects improve. While beyond the scope of this article, the implications that negative rates on long-term bonds would have on investors and pension plan sponsors are far-reaching.

Based on economic expectations, we would anticipate long-term rates to stay range bound to a new, lower range. We expect yields on 10-year Treasuries to move between 0.50% – 1.00% and on 30-year Treasuries to stay between 1.00-2.00%.

2. Inflation expectations. There is a strong relationship between long-term interest rates and expected inflation. Higher inflation leads to higher nominal interest rates, but with a lag.

Current expectations of inflation (which can be calculated by subtracting the yield of Treasury Inflation Protected Securities from the yield of normal Treasuries of the same maturity) implies a long-term inflation level of around 1.50%, which is below the 1.75-2.00% we have seen over the past several years.

How might we see a pickup in expected inflation?  Expected inflation could rise if the following occurs:

• The economy starts to overheat on the back of fiscal and monetary stimulus.
• The economy bounces more quickly than expected because of a major breakthrough with the pandemic.

Right now, most central banks are more concerned about deflation than inflation. Many, including the Fed, would be likely to allow expected inflation to be higher than their target for some time before taking action such as reversing QE or raising interest rates to try and bring inflation under control.

3. Expectations for the Fed Funds Rate. With the Fed's moves in March, and its view on negative rates, there's hopefully nowhere to go but up from here with Federal Funds Rate.  The main question on everyone's mind is when the Fed will begin its tightening process.  This timing has significant implications for both short and long-term rates.

The market is currently pricing in no rate increases through 2021.  The Fed will need to see the economy on a strong footing before it begins the process of removing stimulus — and given the virus, the timing will be some time from now.

Credit spreads

Credit spreads are largely driven by equity market volatility and default expectations. While we are in the midst of a deep recession and the fundamentals of many companies are seriously impaired, credit spreads on all but the weakest companies are not much wider than they were at the beginning of the year. The primary reason for that is that the Fed stepped in to provide a full backstop to any company with an investment grade credit rating as of late March. The risk of bankruptcy for these companies, at least over the short-term, has been alleviated.

The Fed has also provided support to non-investment grade companies and to smaller companies of all types, all of which has helped credit spreads to recover.

While spreads are still a bit higher than they were to start the year, they are not nearly as high as they would be otherwise. There is still elevated default risk in the sectors hardest hit by the pandemic such as energy, travel and physical retail. And there are potential long-term negative effects from the steps the Fed has taken.

However, for now investors with significant holdings of long-term investment grade bonds, such as many corporate pension plans and insurance companies, can breathe a little easier as we expect the Fed backstops to be sufficient to stave off a large number of bankruptcies.

The flip side of this is that tighter credit spreads also means lower pension liability discount rates, and therefore higher reported liability values.

Pulling it all together

Given all of the drivers of interest rates, where do we see rates going from here – especially the yields on long-term corporate bonds used to set pension liability discount rates?

What we are likely to see from the Fed: Given the scale of unemployment, the likely timetable for full economic recovery from the pandemic and low expected inflation, the Fed will most likely hold short-term rates at zero for several years.

What we are likely to see for longer-term interest rates: Longer term interest rates are a function of: expected real GDP growth, inflation expectations, and expectations of the level of the Fed Fund Rate.  While real GDP growth can return to trend within the next couple of years as the direct effect of the pandemic subsides, we expect inflation expectations to remain low and for short-term interest rates to remain near zero for several years.

We therefore expect long-term interest rates to stay in their new, lower, range for the foreseeable future. These rates will stay in this lower range until unemployment reaches levels where the Fed can begin to increase short-term interest rates.

Credit spreads will fluctuate with equity markets, default expectations and the timing of removal of any backstops the Fed has in place.

Long-term corporate bond yield should be flat to lower as Treasury rates will be range bound and credit spreads should migrate tighter. Central bank programs should support further tightening of credit spreads through the rest of this year, unless there are other factors (e.g. geopolitical events, prolonged pandemic, and the US election).

For corporate pension plans with liability values linked to longer-term, high-quality corporate bond yields, we would not expect any meaningful near-term improvement in funding levels to come from significantly rising interest rates, and indeed can see rates moving lower from here.

What could change the outlook? The current outlook will continue to be affected by the pandemic. If the pandemic is not brought under control, then the resulting weakened economic conditions will put additional downward pressure on rates. Conversely, development and faster-than-expected deployment of an effective vaccine would be a catalyst for quickly improving economic conditions and support higher interest rates.  However, faster-than-expected recovery is still a 2021 event.

What investors can do

There are always unknowns when it comes to interest rate movements. Based on the current economic environment and the pandemic, low long-term rates are likely here to stay for at least the next 1-2 years, with near-zero short-term likely for several years after that. For investors, especially those with interest rate-sensitive liabilities like corporate pension plan sponsors, revisiting asset allocation strategies is paramount. Investors will need to take a holistic look at their expected return and risk profiles along with liquidity needs and decide if they need to do something different to have success over the long-term.

Michael Clark is a Managing Director and Consulting Actuary in River and Mercantile's Denver office and is the current President of the Conference of Consulting Actuaries.

Phil Gorgone is a Managing Director and Head of Investments in River and Mercantile's Boston office.