Interest rates: Expectations for moving higher

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 might go in the future. Looking back to last year, we forecasted that without a substantial improvement in global economic growth expectations long-term interest rates wouldn’t move significantly higher. Global economic growth expectations, and inflation expectations, have indeed increased since then and long-term rates followed the trend higher, though perhaps not as high as many had hoped and have fallen off slightly since March of 2021.

Why the pause in rising yields?  The pickup in COVID cases due to the Delta and now Omicron variants as well as the economic slowdown in China have been two of the leading drivers of the pause in the upward trajectory.  Higher inflation, partially due to supply shocks, should be goading long-term rates higher, while short-term rates are being held at bay by the Federal Reserve.

Our forward-looking view is that long-term rates are primed to move higher, to a degree. With credit spreads remaining tight and government bond yields positioned to move higher, long-term rates should be increasing over the next couple of years.

The rest of this article looks at how the current economic environment is affecting interest rates and what may well cause the volatility in rates to continue. In particular:

• The drivers of short- and long-term interest rates;
• How those drivers have affected rates year-to-date; and,
• What could cause rates to change going forward.

Market recap

The US Treasury yield curve has steepened (steep = long-term rates significantly higher than short-term rates) considerably over the last two years, with short-term rates falling significantly as the Fed cut overnight rates to zero in response to the pandemic and inflation expectations rising as we begin to exit the pandemic.  More recently, the market has started to price in quicker and more aggressive interest rate increases from the Fed, which has caused the curve to flatten as short-term rates have risen.

The chart below shows the dramatic difference in Treasury rates from before the pandemic to today.

Source: www.treasury.gov

Corporate bond rates have followed a similar pattern to Treasury rates as investment grade credit spreads have only modestly narrowed year-to-date.

Treasury yields currently imply that the Fed will start to raise interest rates in mid-2022 (two 0.25% hikes in 2022) and will continue to raise them in 2023 (three 0.25% hikes). A key driver of when and how fast the Fed raises interest rates is inflation. The Fed’s long-term inflation objective is 2%. However, the Fed made a key change recently in articulating that it would like inflation to average 2% over time rather than seeing 2.0% as a level to take action.

Inflation was below 2.0% for many years through 2020 and targeting average inflation means that the Fed will be comfortable allowing inflation to remain above 2.0% for some time, so long as it does not stagnate the economy. The Fed is currently being put to the test, with recent monthly headline inflation readings running at 5.0%-6.0% annualized and market-implied long-term inflation expectations rising to over 2.5%.

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.

The Fed took swift action in March 2020 to reduce the Fed Funds Rate to 0.00% – 0.25%, and it’s remained there ever since. Inflation is on the rise and the Fed’s prior statements on its willingness to allow inflation to go beyond their long-term target of 2.0% without raising rates is now a reality. Now the question becomes at what point the Fed will raise the Fed Fund’s Rate to try to curb rising inflation.

The unemployment rate has continued to come down considerably from Q2 of 2020 when it reached almost 15%, but it’s still not back to pre-pandemic levels. Our big questions last year were around whether certain jobs would come back at all with technology accelerations that have changed the way that work is done. The other interesting development is with some minimum wage jobs where there are openings that are not being filled. It’s hard to know if this is being driven by a labor shortage for these types of jobs or is a result of unemployment or other financial assistance from the government. These questions are still in play today.

At this point it looks to be a matter of when, not if, the Fed will change course. If unemployment continues to decline, or if inflation expectations continue to be viewed as more than just “transitory”, then the Fed could be forced to raise interest rates sooner rather than later. Currently markets are expecting rate hikes to start happening in the middle of next year.

Long-term interest rates

“Long term rates” are the yields available on bonds with over 10 years in maturity.  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 Treasuries have bounced back from the historic lows seen in 2020. The 10-Year yield bottomed out near 0.50% in August 2020 and broke through 1.8% earlier in 2021, before retreating to current levels of around 1.5% at the beginning of December. The 30-Year also found its way back to early 2020 levels in March, but retreated from those highs and has settled around 2.0%.

Longer-term rates tend to move with: 1) economic conditions; 2) inflation expectations; and 3) 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).  Given the level of inflation and GDP growth, we would expect long rates to push higher and then level off as inflation and growth start to moderate.  The 10-year Treasury rate should move closer to 2.0% and the 30-year Treasury closer to 2.5% with a near-term floor of around 1.4% and 1.8%, respectively, assuming no major “Black Swan” events.

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. Nominal GDP has grown over 5.0% in the first half of 2021, and the 10-Year Treasury rate increased from 0.93% to 1.45% over that same period.  Today we are witnessing rising GDP and increasing inflation expectations.  Long-term rates have also been trending directionally higher even with the pullpack from the highs we saw in March 2021.  The question now remains whether they will pull back more or if they’ll reverse course and move higher as the pattern of long-term nominal GDP growth to Treasury yields would would suggest.

Based on economic expectations, we would anticipate the 10-year Treasury rate to stay range bound but trend closer to 2:00%. Volatilty in interest rates should remain high given virus variants, supply chain disruptions, and other geopolitical events.  That said, based on economic expectations we anticipate yields on 10-year Treasuries to be between 1.4% – 2.0% and between 1.8% – 2.5% on 30-year Treasuries until the Fed begins moving short-term rates higher in mid-2022.

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 long-term 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 an inflation level of around 1.5%, which is below the 1.75% – 2.00% we have seen over the past several years and below the Fed target of 2.0%.

We are now clearly seeing the ramifications of fiscal and monetary stimulus on inflation as a result of the various measures taken to soften the blow of the pandemic on the overall economy. Various outlets are predicting short-term inflation to remain in the 4.0% – 5.0% range with long-term inflation settling in at the Fed’s target of 2.0%. How quickly inflation goes from current levels to the long-term expectation is to be seen, but the Fed’s actions could push inflation levels back to target sooner rather than later.

Expectations for the Fed Funds Rate

All signs point towards the Fed increasing rates several times over the next two years. As we’ve mentioned in other parts of this article, the market is already pricing in two rate increases in 2022 and three increases in 2023. These increases are all based on the economy continuing to show positive signs as the Fed has stated that it’s willing to deal with short-term inflation.

What could cause the Fed to push pause on these anticipated increases? While the pandemic seems to be slowly winding down, it’s not over yet. Any additional variants that emerge or resurgences in the winter months in the northern hemisphere that could cause the pandemic to continue to prolong and continue to affect supply chain issues could cause the Fed to tread lightly on future anticipated rate hikes.

Credit spreads

Credit spreads are largely driven by equity market volatility and default expectations. At the onset of the pandemic in March 2020, credit spreads widened significantly (i.e., rise in the likelihood of defaults) but have pulled back to near or below pre-pandemic levels.  The measures put in place by the Fed in 2020 to provide a backstop to investment grade companies has clearly paid off.  Credit spreads can remain tight as long as the economy continues on its current course.  There will be a time when the economy does slow down and the market begins to price in a higher premium for default risk, but there’s no reason to think that credit spreads will widen out in the short-term without some major event or resurgence from the pandemic.

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:

The Fed has indicated that they will not be raising short-term rates until they have finished tapering their monthly purchases of Treasuries and mortgages ($120b).  The tapering process has begun ($15b per month) and should end sometime in the middle 2022.  At that point, they will consider raising interest rates.  However, if inflation doesn’t abate and/or unemployment continues to drop, then they may be forced to either speed up their taper or raise short-term rates sooner.

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.  Real GDP growth has bounced back beyond pre-pandemic levels and inflation expectations are high, at least for the next couple of years. Without moderation in growth or inflation, we expect the general upward trend in long-term rates will continue.

If interest rates move high enough, that will put pressure on the economy and may force a repricing of credit risk.  For corporate pension plans with liability values linked to longer-term, high-quality corporate bond yields, we expect some near-term improvement in funding levels to come from rising interest rates, while credit spreads should remain narrow for at least the next three to six months.

What could change the outlook?

The current outlook will continue to be affected by how the global economy deals with fits and starts related to virus resurgence and higher prices for goods and services.  If the pandemic continues to dwindle, we foresee interest rates continuing to move higher.

While the focus recently has been on infection levels and inflation, other known and unknown geopolitical events could upend the current forecasts – this is always the case.

Take a holistic look

There are always unknowns when it comes to interest rate movements. Based on the current economic environment and where we sit with the pandemic today, long-term rates are likely to push higher, with short-term rates primed for increases over the next two years. For investors, especially those with interest rate-sensitive liabilities like corporate pension plan sponsors, revisiting asset allocation strategies in these environments is imperative. Investors will need to take a holistic look at their expected return, risk profiles, and liquidity needs and decide how they want to position themselves for the next couple of years.

Michael Clark is a Managing Director and Consulting Actuary in River and Mercantile’s Denver office.

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