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AAM Viewpoints – Will Interest Rates Continue to Rise?

There has been ample discussion on where interest rates are headed and naturally many different views. The 10-year U.S. Treasury bond is hovering around a 2.90% yield. This yield already represents a 50+ basis point (bps) move higher since the first of the year. The question is whether the move toward higher rates has more to go.

Economic Indicators & Tighter Spreads; Reversion to the Mean

Economic Indicators

The price of metals is seen by many as an indicator of economic growth. Copper, aluminum and steel are metals that are used across the industrial complex for houses, autos, factories and equipment. A rise in the price of these metals indicate a greater demand, and thus could indicate a growing or vibrant economy. The S&P GSCI Industrial Metals Index is currently at its highest price over the past five years after coming off its lows in early 2016. A robust economy would lead some to think this could be inflationary, fueling higher interest rates.


Source: Bloomberg

Initial Jobless Claims track the number of people who have filed for unemployment benefits for the first time; this can be seen as an indicator of how well the economy is doing. If this number is low that means there are plenty of jobs and if the number is high it is a reflection of the lack of jobs available, thus a weaker economy. The monthly initial jobless claims during the last quarter has been the lowest it has been since the early 1970s, nearly 50 years ago. Although it does not always hold true, this may lead to an increase in wages to lure potential hires where they are needed, which may lead to inflation…see the late ‘70s early ‘80s.

Tighter Spreads; Reversion to the Mean

The Consumer Price Index (CPI) is a measure of the prices paid for consumer goods. It is the belief of many that the growth rates of the CPI indicate inflation rates. The CPI is at 2.4%, and other than early 2017 it is the highest in five years. But more interesting is the average spread between the 10-year Treasury and the CPI over the last 20 years. The 10-year treasury currently sits at a yield of a 2.90. That puts the spread between the 10-year Treasury and the CPI at 51 bps. That 20-year average is 148 bps, which means the spread between the two is 96 bps tighter than the average. If the reversion to mean even loosens half that, this alone means the 10-year Treasury should be around a 3.40% yield.


Source: Bloomberg

It is probable that the Fed will raise the Fed Fund Rate three more times in 2018. The Fed Funds Rate is currently at a 1.75%. Assuming a 0.25% raise each time, that would have the Fed Funds Rate at 2.50% by the end of this year. Currently with the 10-year around that 2.90% and the Fed Funds Rate is at 1.75%, this spread is 115 bps with the average spread over the last 20 years at 156 bps. Once again, any reversion to the mean will likely result in higher interest rates.


Source: Bloomberg

Just because the Fed raises the Fed Funds Rate does not mean that longer maturity rates will rise as the Fed Fund Rate only directly impacts shorter maturities. That would mean that if only the short end rates rise then we are looking at a flattening yield, or in the event of an inverted yield curve that a recession is looming in the future.

Given the economic indicators, tax cuts fueling the economy and spending bills being considered, we do not believe the economy or inflation will be slowing down. Besides, the booming budget deficit will require more borrowing by the government up and down the yield curve resulting in higher rates. The more monies needed to be borrowed the higher rates may go. However, there are always two sides to every story and as always check with your financial advisor before investing.

 

CRN: 2018-0402-6530 R

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 commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.