In our recent piece “The High Yield Bond Market: Facing a Rising Rate Environment, Time to be Concerned?” we discussed why we don’t feel the high yield market is at major risk if rates rise. And as we look toward the likelihood of the first interest rate increase in nearly ten years this week, we felt it was appropriate to review our outlook on rates. In short, we are in the moderate camp; we don’t expect the Federal Reserve to be aggressive with rate increases. The Fed clearly wants to start raising rates, as we are eight years into this “recovery” and cycle, and frankly, they need to have some room down the road to ease if necessary. But the data isn’t there for this “data dependent” Fed to justify significant and quick increases. We’d expect a few sporadic rate increases over the next year for the Federal Funds Rate, the interbank lending rate that the Fed controls. We’d also expect that these Federal Funds Rate increases do not translate to massive spikes in the 5- and 10-year Treasury rates, the relevant rates for the high yield market.
We recently discussed in our piece “Making Sense of Markets” the primary reasons that we believe the Fed will be constrained in their ability to raise rates. In summary, here are the challenges we believe they face:
- Growth: We are in a no growth world. China is clearly slowing, Europe continues to muddle along, and Japan is in a recession. Global conditions are having an impact here domestically, as evidenced by the latest earnings season and the projected 4.4% decline in Q4 earnings.1
- Inflation: With oil and commodity prices yet again taking another leg down, we believe the Fed will be hard-pressed to reach their inflation target of 2% in the “medium term.”
- Unemployment: While the headline unemployment number has improved, there is still a large contingency of underemployed and discouraged workers dropping out of the job hunt, and we know this is something the Fed monitors based on previous comments.
- Consumer Spending: Approximately two-thirds of economic activity is consumer driven. With nearly 50% of Americans now on some form of government assistance and the massive number of people that have fallen out of the job market, there seems to be less spending power today than a decade ago. Many have said that the energy cost savings will spur consumer spending but that just isn’t playing out as money is being used to shore up other cost increases.
- Dollar: The strong dollar continues to cut into corporate profits, manufacturing, and exports.
All of these factors we believe will keep the Fed constrained in the speed and magnitude as they increase rates. While the Fed impacts the Federal Funds Rate, there are a couple other factors that we believe will play into keeping 5- and 10-year Treasury rates from running up significantly from here.
- Global Demographics: As we have written about before, we are facing ageing demographics globally. As people age, we’d expect them to focus more on income and capital preservation, meaning we’d expect to see the demand for bonds to increase and stocks decrease over time.
- Global Rates: With the lack of inflation globally, 10-year sovereign bond rates across the globe are exceedingly low. The US is an outlier with our 10-year over 2%. Even countries that were on the precipice not too long ago, like Italy and Spain, have 10-year bond yields well below that of the US.2 Given these comparative rates globally, we’d expect there to be buyers of the higher yielding 5- and 10-year U.S. Treasuries, in turn constraining rates on these debt instruments.
Given that it seems a foregone conclusion that the Fed will be raising rates this week and markets are forward looking mechanisms, we believe the Treasury rates are already pricing in a rate hike. With that, over the past couple months we have seen the 10-year pretty range bound around 2.15-2.35%. Between the still tepid economic situation worldwide tempering the Fed’s hand and demographics and relative rates globally driving demand for US Treasuries, we don’t see relevant interest rates running significantly.
The Federal Reserve will likely start raising rates to get the ball rolling, and may move rates up a quarter of a point a few times over the next year, but we expect their move to be fairly minimal. Additionally, given how the high yield market has historically handled rate increases, we’d certainly not expect this moderate move to inflict great pain on this segment of the market as many seem to worry will happen.
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