What the Fed’s Great Unwind Means for Rates
The Beginning of the End of QE (“Quantitative Easing”). Its been well advertised the Fed will begin unwinding its $4.5 trillion-dollar balance sheet this month, initially by reinvesting a gradually smaller amount of Treasuries and allowing Mortgage-backed securities to mature without replacement in its massive portfolio. As such, October 2017 will go down in history as the official end of the QE era.
The Fed – and everyone else for that matter – is wondering what effect this will have on interest rates across the curve. To answer this question, its best to analyze two factors: the term premium and the state of the the broader, global economy.
Term Premium: What is it and why you should care
Term Premium, as it relates to government bonds, is essentially the additional return investors demand for investing in longer dated bonds versus shorter ones; where the outcome over the long-term is far less certain than that in the near term, and hence, investors demand higher returns from bonds with longer dated maturities. The Term Premium is and has been exceptionally low for years, driven and kept there by two factors: Global central banks QE-driven bond buying and the lack of inflation in the economy. To quantify the Fed’s QE impact on yields, its been widely estimated that the Fed’s policies have made the 10-year Treasury yield artificially lower by ~50 basis points.
A Quick Look in the Rear-view Mirror
Over the past eight years – during which the Fed embarked on several of its bond buying, monetary easing cycles – yields rose when the Fed was in buying mode and fell when it stopped. That’s the opposite of what was expected and totally counter to the inverse relationship between a bond’s price and its yield. As financial text books state, if there’s a major buyer in the market – the Fed – driving up a bond’s price, then the bond’s yield should fall, not rise. So, what happened?
The most basic market participants focus on what the Fed is doing and how its actions effect markets in the simplest cause and affect, text book sense. Markets are more complicated than that, in that while they care what the Fed is doing, what really matters is how the Fed’s actions influence the economy over the long-haul. The Fed’s QE efforts spurred hope in the markets that faster growth and higher inflation would be around the corner, spurring investors out of Treasuries and into other assets that would appreciate in such a scenario, e.g. equities and real estate. When the Fed wasn’t buying Treasuries – in the periods between QE – markets were left to focus on the doldrums of the post-crises era economy, where high growth and inflation seemed far off.
The Great Unwind
Now that the Fed is putting its QE/bond buying activity in reverse – providing less stimulus to the economy – the text book logic would be to assume that long-term rates would rise, but the history of QE tells us just the opposite, that bond yields will fall. Which is correct?
The “Yields will Rise” camp says, in addition to the textbook reasons, the US Treasury’s need to finance the US budget deficit combined with the Fed’s absence as a buyer/financier of new bond issuances will surely drive long-term yields higher. On top of it all, the Fed’s intention to hike again this year and next year will surely equate to higher long-term yields, a larger Term Premium and by definition, a steeper yield curve.
The counter, “Yields will Fall” camp claims that with inflation running well below 2%, an equity market that’s looking stretched, growth that’s respectable but far from its pre-crises levels combined with the yield advantage US Treasuries offer investors over their European and Japanese counterparts, that Treasuries will remain in demand, providing support for prices and a lid on yields. In summary, a static or slightly smaller Term Premium will follow, along with a flatter yield curve.
What we think
Lots of variables and conflicting signals, eh? We feel it’s best to focus on the drivers of investor behavior when making interest rate predictions and avoid guesswork on what the Fed will do, as it’s a small part of the equation.
Long-term rates won’t move significantly higher anytime soon. Here’s why:
- Underlying, consistent demand for US debt: There is persistent, global demand for US Government debt. While the Fed will be buying fewer bonds as part of its balance sheet unwind activity, any Fed sales will be met with equal demand given that the US has the highest long-term government bond yields in the developed world. Despite their progress toward economic rehabilitation in business, banking and capital markets after the financial crises, Europe, China and Japan won’t catch up to our economic progress for years. Their inherent demand for US sovereign debt will support bond prices and keep yields low. Should geo-political tensions flare up – a real possibility – then demand for US Treasuries will become even greater.
- A lack of inflation drivers: Markets have a sanguine view on the outlook for higher wages and prices; there is just no single reason interest rates will rise dramatically anytime soon. Investors who believe inflation will remain low and wages stagnant feel safer buying long-term bonds because their investment returns won’t be eroded by a sudden jump in inflation. The Fed recently stated officially that it may raise rates in the absence of rising inflation, backtracking on many years of proclaiming that it believed inflation would hit its 2% target and serve as the driving force behind rate hikes. It hasn’t happened yet and won’t suddenly. Rather, inflation will surely rise – eventually – but it will be a slow grind higher over many quarters.
- Despite the encouraging quarterly read of 3% GDP, America’s economic recovery is fragile: America’s recovery over the past decade has been built on flimsy foundations. Much of the job creation has been millions of low-paying, service industry jobs, which often come with low or little pay raises and no security. Much of the growth in consumer spending has been fueled by consumer borrowing, since real wage growth is nowhere to be seen. Business investment remains nascent, with most of corporate profit gains over the last several years achieved through cost-cutting rather than top line revenue growth. It’s a situation where successive Fed hikes aren’t called for and one where caution – as expressed in demand for safe-haven investments like long-term Treasuries – is the watchword. Even more so, the current 10-year yield of 2.35% is nearly as much as the average 2.38% dividend yield of riskier global stocks. This dynamic supports demand for Treasuries, also upholding their prices and capping their yields.
- The eroding support for Trump-driven fiscal reforms: As markets await the next controversial tweet, its looking increasingly likely that Trump’s bark is louder than his bite and the administration’s attempts at immigration, tax and infrastructure reforms will be either significantly watered down, delayed or dead. As a result, demand for long term Treasuries will remain intact as investors seek safety amid growing uncertainty, thereby reducing the probability yields will rise markedly in the near-term.
To float or not to float?
Faced with strong opinions on the future direction of interest rates, plenty of financial officers are wrestling with whether to borrow at a fixed or floating interest rate, after witnessing such a low rate environment for so long. While the decision is driven by one’s view, the difference between a fixed and floating rate loan can be one percent or more, a home run if you call it right, but significantly higher interest cost if you’re wrong.
Over the last decade, savvy borrowers have stayed floating as long as possible as the savings offered by floating versus fixing has been significant. One possible solution to the quandary regardless of your view on rates: Borrow floating and hedge a portion of the debt via an interest rate swap, cap or collar. While every borrower has different goals and objectives, floating rate debt should always be part of the financing conversation.
Not comfortable with floating interest rates like LIBOR, Fed Funds or Treasury yields? There are ways to get educated and open up a world of financing alternatives. Ask us how.
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