Another Fed false start

Grid with arrows increasing and decreasing

Like an overanxious Olympic sprinter, US interest rates can’t seem to gain their footing and exit the starting blocks. Each time rates look ready to liftoff towards normal, there seems to be a false start. As we’ve seen in previous years, interest rates are lower now than when the year began, even though the US Federal Reserve and the so called “experts” told us to expect otherwise. The rate on the benchmark 10-year US Treasury began 2015 at 2.17%, fell to 1.64% in late January, and ended the quarter at 1.92%.

The reasons for the swings and (ultimately) lower yields are similar to what we’ve seen in the recent past, and at the same time both foreseeable and unpredictable. The European Central Bank (ECB) finally initiated bond purchases as part of their promise to do whatever it takes to save the Eurozone. Short term European interest rates went negative, and the 10-year German Bund ended the quarter at .20%. This foreseeable action was accentuated by the unpredictable actions of the Swiss National Bank (SNB). Barely two weeks into the New Year, the SNB decided to delink the franc from the Euro, effectively revaluing the Swiss currency against most other tier one nations. In chaotic trade immediately thereafter, the franc soared as much as 30% against a basket of major currencies. A third event that briefly drove US yields higher was Saudi Arabia’s incursion into Yemen. Although all of these actions had differing effects on stocks, gold, the dollar and the price of oil, the ultimate outcome for US interest rates is always the same: rates go lower. The flight to quality into US Treasuries is the only constant in an otherwise inconsistent pattern of events and responses.

The bond market either doesn’t believe Fed Chair Janet Yellen’s hints about a coming interest rate hike, or it doesn’t believe any increase will have the intended effect of pushing up rates more broadly. In theory, the Fed can only control the rate member banks charge one another for excess reserves, but as short term lending rates increase, these increases should extend further out the yield curve, leading to higher long term rates as well. Throughout history, short-term purchases or sales of reserves have been sufficient to control rates. However, the scope of the Feds involvement has changed dramatically since the great recession of 2008. Nearly seven years of consistent bond purchases by the Fed (Quantitative Easing) have left the central bank with the ability to directly control long-term interest rates by simply selling some of their massive hoard of Treasury and mortgage bonds. The Fed could now use their balance sheet as a way to encourage higher long-term rates if they so desired. With the stronger dollar, lower oil prices and lower worldwide interest rates, the Fed seems to be swimming against the tide in their stated goal of raising rates. Time will tell if they are able to remove the zero rate policy and return to a normal rate environment.

Similar to what we witnessed in 2014, higher Treasury bond prices in 2015 have led to strong price performance for both high grade corporate bonds and intermediate municipals. According to Bloomberg LLC, high grade corporates are up 1.03% and intermediate munis are up 1.11% for the year to date. Eventually, like the sprinter trying to get out of the blocks, interest rates will rise. But the Fed is still fooling with the starter pistol, so rates remain low in anticipation.

Nathan Boxx, Bradley Newman, Jason Seltzer

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