Interest Rates, Potential Economic Scenarios and Investment Thoughts

While much of the current economic news has been positive, there are signs that rising interest rates are starting to take a bite out of the economy. Recently, the Atlanta Federal Reserve revised its forecast for 1Q Gross Domestic Product (GDP) growth down from more than 5% to a mere 1.9%. Despite this, The Federal Reserve (“Fed”) seems intent on continuing their path of least resistance by raising rates, despite the fact they acknowledge that inflation, as measured by CPI, isn’t a risk at this time. While most market watchers agree that interest rates have remained too low for too long, investors should be aware of the long-term market trends we are now testing.

Examining the chart below for the U.S. Treasury 2-year and 10-year bond yields illustrates the market is testing a long-term resistance level dating back to the early 1990s. It’s interesting to note that when the spread between the 2-year and 10-year rates compresses to near zero, it has historically been a reliable precursor to an economic recession (highlighted by the gray bars). Said differently, while the Fed may control short-term interest rates, long-term rates are based on the market’s expectations for future growth. Essentially, the yield curve shifts from its normal upward sloping direction, where long-term rates are higher, to a downward sloping curve, where short-term rates are higher.  During this type of market environment, investors generally tend to place a higher priority on preservation of capital and, as such, rush to buy long-term Treasury bonds. Given the current market environment, we believe investors should pause and consider the following three potential scenarios:

  1. Bond yields begin to fall rapidly: Looking at the charts below, we can see that the long-term resistance levels have historically signaled the top in an economic expansion. If yields fail to breach this threshold then it is most likely due to investors’ lack of confidence in the economy.  This loss in confidence can result in a “flight to quality” trade resulting in US Treasury rates declining rapidly with corresponding price appreciation of these Treasury securities.  Outside of purely historical analysis, the news from the Administration regarding trade tariffs and their implications for global growth going forward could contribute significantly to this “falling yields” scenario playing out in the near-term if cooler heads don’t prevail.  On an economic basis this scenario seems somewhat unlikely given the recent GDP growth numbers and strength in the labor markets. While the yield curve is nearly flat between 2s and 10s, there are other technical factors such as foreign flows that are also weighing on the market.
  2. Bond yields exceed the resistance level: While there is probably a natural limit to how far rates can rise before foreign investors begin buying Treasury Bonds, rapidly rising interest rates may also likely put pressure on businesses as borrowing costs increase. While we haven’t observed this impact in the high yield (HY) market yet (see HY OAS Spread chart below), these companies would likely be the first and most negatively affected by increasing capital costs. The likelihood of this scenario playing out depends primarily on the Fed and the new Chairman’s desire to maintain their stated plan for increasing interest rates.  The market is forecasting three potential rate hikes the remainder of 2018. We’ve already seen the short-term market’s London Interbank Offered Rate (LIBOR) react to this expectation with monetary tightening already taking hold. While we are not in the business of accurately calling the break in a long-term trend, it would seem likely if the economy continues to post 2%+ GDP growth and business activity remains robust, shorter duration assets and those structured to benefit from rising interest rates will do better than long duration assets.
  3. Yields test the highs and then fall back: Frankly, we would put this sequence of events as a lower probable outcome. The scenario would suggest the economy is not running too hot or cold. Unfortunately, the job market is telling us hiring activity is heating up, which would typically drive wage growth, and ultimately inflation, higher. The key here will be the pace of future Fed rate hikes and if they can manage to keep a lid on inflation.

While the recent spate of equity market volatility has gotten a lot of attention, it would be wise for investors not to forget what is happening in the “less flashy” bond market and corresponding interest rate environment. While we don’t believe that the market is poised for a break-out in rising rates, investors should remain mindful of rate trends, and as always, cautious of seemingly certain outcomes. Talk to your consultant or advisor about the differences between core and intermediate fixed income allocations along with high quality corporate debt relative to high yield.  If you are considering more risk, you may wish to consider investments like bank loans (floating-rate securities) as a way to try to benefit from rising interest rates while providing potentially better recovery profiles and lower default rates than alternative traditional high yield bonds.

Important Disclosure Information:

The views and opinions expressed are solely those of AndCo Consulting. This should not be regarded as investment advice or as a recommendation regarding any particular course of action. AndCo does not provide investment advice to individual participants and you should confer with your financial advisor for additional information.

 This document has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon, for legal or tax advice. Certain information is based on sources and data believed to be reliable, but AndCo cannot guarantee the accuracy, adequacy or completeness of the information.

 This article may contain statements of future expectations, estimate, projections, and other forward-looking statements that are based on available information and AndCo Consulting’s view as of the time of those statements.  Such forward-looking statements are inherently speculative as they are based on assumptions which may involve known and unknown risks and uncertainties.   Actual results, performance or events may differ materially from those expressed or implied in such statements. 

 Opinions expressed reflect prevailing market conditions at the time this material was completed and are subject to change. Moreover, the material provided herein is valid as of the date of posting and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after such date. 

 AndCo Consulting is an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”). Registration as an investment adviser does not constitute an endorsement of the firm by securities regulators nor does it indicate that the adviser has attained a particular level of skill or ability.

34th Annual FPPTA Conference

June 24-27, 2018

Orlando, FL

The FPPTA Annual Conference draws approximately 2,000 people every year. The conference focuses on a macro-perspective of the industry and public pension landscape over two and one-half days of speakers. Attendees spend time learning from one another ways to protect and grow municipal pension plans.

AndCo Conference Speaker: Mike Welker, CEO

FGFOA Annual Conference

June 16-20, 2018

Orlando, FL

The FGFOA annual conference is held each June in various locations throughout the state. Approximately 1,200 local government finance officials from across Florida attend this meeting to share ideas, attend educational workshops and sessions, and earn continuing education credits.

Pennsylvania State Building Trades

June 2018

Harrisburg, PA

The Pennsylvania State Building & Construction Trades Council is made up of 16 Regional Council and more than 115 local unions from 15 International Building Trades Unions.

PAPERS Spring Forum

May 22-23, 2018

Harrisburg, PA

The annual PAPERS Forum provides both pension plan and corporate representatives with an opportunity for networking and education on a wide variety of pension topics.

MAPERS Spring Conference

May 19-22, 2018

Mt. Pleasant, MI

Michigan Association of Public Employee Retirement Systems (MAPERS) was established to provide educational training and legislative updates to trustees of Public Employee Retirement Systems within the State of Michigan.

CFA Society Pittsburgh Endowment & Foundation Investments Conference

May 16, 2018

Pittsburgh, PA

Join leaders from Endowments and Foundations, investment consultants, money managers, and subject experts for this full-day educational conference covering today’s critical investment and governance issues.

This year’s conference will include a mix of regional and national speakers from investment organizations and the Endowments and Foundations community, a keynote lunch presentation, and a CIO Roundtable.

AndCo Conference Speaker: Tim Walters, Senior Consultant

NCPERS Annual Conference & Exhibition

May 13-16, 2018

New York, NY

More than 1,000 trustees, administrators, state and local officials, investment, financial and union officers, pension staff and regulators attend the NCPERS Annual Conference & Exhibition each year. Attendees benefit from the comprehensive educational programming, dynamic speakers, and networking opportunities with money managers, investment service providers and public fund colleagues from across the nation.

GFOA 112th Annual Conference

May 6-9, 2018

St. Louis, MO

GFOA’s 112th Annual Conference offers an opportunity for public finance professionals from across the United States, Canada, and the world to share ideas, develop technical and managerial skills, view new products, and network with peers.

IPPFA – Spring Conference

May 1-4, 2018

East Peoria, IL

IPPFA’s Spring Conference offers trustee training to public pension trustees. With the recent far reaching changes in pension law and with the difficult challenges yet to come, the IPPFA strives to prepare pension trustees for the future.