Push and Pull
Read the weekly bond market commentary from Drew O’Neil.
As with any price or value that is determined by free markets, there are forces currently pulling and pushing interest rates in different directions. On any given day, you can find various pundits calling for both higher and lower rates. Knowing that this can be a lot to digest, the following may provide some clarity on the different forces currently at play.
Pushing US Interest Rates Higher
Inflation Inching Higher – A major driver of interest rates and the yield curve is inflation and future expectations of inflation. The market demands higher interest rates as compensation for the higher inflation. Recently, measures of inflation have been inching higher, pushed up by low unemployment, policy changes, and economic growth. There are no signs of “runaway” inflation but recent data is approaching the Fed’s target of 2%.
Tax Cut Fueled Growth – Economic growth can push interest rates higher. As the economy does better, people spend more money, which in turn pushes inflation higher. Tax reform lowered both corporate and individual tax rates, which at a fundamental level puts more money in the pockets of individuals/companies to spend and fuel economic growth.
Scaling Back Quantitative Easing – The world’s major central banks have intentionally pushed interest rates lower in an attempt to fuel economic growth. They have done this by lowering their benchmark rates and by pumping money into the economy through open market bond purchases. These massive purchasing programs push demand higher than their “natural” levels, driving prices higher (higher prices = lower yields). The Fed began raising its benchmark rates in late 2015 and has recently begun shrinking its balance sheet while other central banks have implied that they will begin to follow suite in the not-too-distant future. The Fed’s actions combined with the mere suggestion that others will follow has encouraged higher rates.
Fed Rate Hikes – The Federal Reserve began raising their benchmark rate in 2015 and many are predicting they will raise rates 2-3 more times in 2018. Although the Fed’s direct influence is on the ultra-short end of the curve, any action by the Fed can influence the market’s outlook on the direction of the economy and by extension effect rates all along the yield curve.
Pulling US Interest Rates Lower
Money Created by Central Banks – Although the scaling back of “easy money” created by the world’s central banks has begun or is being talked about, there is still an enormous amount of money on their balance sheets (over $20 trillion combined) that is essentially free cash flow created out of thin air that is working to keep interest rates suppressed.
Foreign Sovereign Rates – US Treasuries still offer very attractive yields compared to other high-quality sovereign issuers. This is enticing foreign money to flow into US bond markets, helping to keep prices high/interest rates low. A good indicator of foreign interest is the indirect bidder participation in Treasury auctions. The 5, 7, 10, and 30 year Treasury auctions this month have had healthy indirect participation of 58-68% (Source: Bloomberg LP).
Geopolitical Uncertainty – Geopolitical instability, or the potential for instability, can drive investors to seek “safe-haven” assets, which oftentimes takes the form of US Treasuries. As money shifts into Treasuries, prices increase and yields decrease. This instability can be caused by developing news with current “situations” (North Korea, instability in the Middle East, Brexit) or could be triggered by unforeseen shocks to the global environment. Major global events or even investors’ expectations concerning event risk is enough to pull interest rates lower.
The “push and pull” factors will slowly play out potentially lending a clearer directional interest rate move. In the interim, the factors have stirred more volatility and a slight rate increase that is yet to demonstrate whether it has enough force to continue or is too diluted and more range bound.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.