INSIGHTS

On February 01, 2016

AAM Viewpoints - Expect the Unexpected

If there is one lesson markets teach us time and time again it is to expect the unexpected. The markets have a way of zigging as the herd waits for the zag and expectations for the future direction of interest rates are certainly no exception. As active participants in the fixed income markets we have seen the unexpected creep up over and over again with regard to the U.S. rate outlook. We can count on one hand the number of prognosticators who have been able to accurately and consistently call the direction of interest rates and the question confounds even the most seasoned of economists. Perhaps the most extreme example came in the spring of 2014. On April 22, 2014 Bloomberg published their monthly interest rate survey, asking 67 economists where the 10-year U.S. Treasury yield would finish by year end. All of the 67 economists surveyed called for higher rates from the then-current 10-year level of 2.73%. The question at the time was not, “Will the 10-year break 3% by year end?” but “How quickly will it get there?” The balance of 2014 brought weakness in energy and commodity prices, concerns over global growth and a spate of weaker-than-expected domestic economic data and all 67 economists turned out to be wrong. The 10-year finished out the year at 2.17%

Ironically, the 10-year currently sits at approximately 2%, down roughly 30 bps (basis points) since the first FOMC (Federal Open Market Committee) rate hike in 10 years on 12/16/2015. This along with concerns over global growth, the potential for a “hard” landing in China, questions surrounding the domestic economy, falling commodity prices and expectations for a stronger dollar leave most calling for a muted rate environment with little to no potential for a sustained meaningful movement up in rates. Many economists and market participants are actually calling for rates to move down to the 1.50% range and we are now hearing talk of the need for more accommodation and the potential for a FOMC cut in 2016.

A conversation on interest rates, especially in the short run, is really a question of inflation and inflation expectations as inflation is the key driver behind interest rate movements. Whether you consider a lagging measure of inflation such as the headline CPI (Consumer Price index) or a more leading indicator such as Treasury TIPS (Treasury Inflation Protection Securities) Breakeven Rates, there looks to be little to no inflationary pressures. Consumer inflation expectations hit a nine-year low last week, TIPs markets are pricing in the lowest level of inflation since the credit crisis and survey results indicate most market participants see little inflation on the horizon.

Source: St. Louis Fed

This is occurring in the most accommodative global monetary environment in the history of the financial markets as central banks around the world provide liquidity to markets in an effort to generate inflation. While it may appear that these institutions are struggling to achieve their aims, we are beginning to see some signs of inflation on the horizon. It is important to keep in mind that, theoretically, these institutions have unlimited resources to put to work. They have committed to providing stimulus and will do so until they are comfortable with the direction of inflation. This is could be why we are seeing such a divergence between central banks expectations for inflation and what we are seeing priced into the market. Should central banks achieve their goals and we see even a slight increase in either the level of inflation or inflation expectations, we could see rate volatility along with higher rates over the course of the next year.

An unexpected uptick in either inflation or inflation expectations could come from a number of factors over the course of 2016. First, global markets are currently pricing in a worst case scenario with regard to global growth. This is especially evident with regard to China with conversations centering on the impending “hard” landing. Should we see even a marginal improvement in economic data coming out of China markets could be forced to increase global growth expectations which would in turn drive up inflation expectations.

A weakening U.S. dollar could also stoke inflationary pressures. While it seems counterintuitive that the dollar would weaken as the United States lifts interest rates, it is certainly not out of the realm of possibility. Markets, by their nature, discount future events. Price movements in markets today reflect investor’s expectations surrounding events in the future. One would expect a strengthening currency in economies with tightening monetary policy, but this strengthening is many times discounted against before the first rate hike. The U.S. dollar has actually weakened approximately 50% of the time after the initiation of the first hike in a tightening cycle. The strong rally in the U.S. dollar across 2015 could have been the markets pricing in expectations ahead of the first rate hike and weaker dollar in 2016 as a possibility. Should the dollar weaken, by even a small margin, inflation expectations would most likely increase.

Headline CPI could also begin to converge with Core CPI in the near future which would likely result in an uptick in expected inflation. Headline CPI – currently at 0.7% on a year-over-year basis – is at one of the lowest levels post credit crisis. About 70% of the drop in Headline CPI over the last 18 months is attributable to the fall in energy prices.

Source: St. Louis Fed

Core CPI, on the other hand, which excludes food and energy, has actually been trending upward over the last 12 months and currently stands at 2.1%. Some sub-indices of the CPI, such as medical commodities and services, are actually increasing on a year-over-year basis at more than 3%. Any stabilization, much less increase, in the price of energy could result the headline number moving higher to converge with the Core CPI reading. A surprise to the upside in the headline number could result in increasing inflation expectations and higher rates.

Finally, wage growth in the United States, traditionally a driver of inflationary pressures, has been tepid to date. This is unusual in an environment with unemployment under 5%. In most cases falling unemployment leads to increasing inflation via wage growth. Historically there is a lag between a drop in unemployment and increasing inflation. As we near what the Federal Reserve considers full employment we could see the rate at which wages are increasing begin to improve. An increasing rate of wage growth would signal future inflation and could lead to higher rates. 

   

Source: St. Louis Fed

While trying to call or time the direction of interest rates is probably not a good course of action for most long-term investors, one should be prepared for the unexpected. A low range-bound rate environment could be the most likely outcome for 2016, but in preparing for the unexpected do not be surprised if we see higher rates by year end.

CRN:  2016-0201-5144R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.