The most common questions received are: What’s your view on the Federal Reserve (Fed)? What’s your view on interest rates? Where is the 10-year U.S. Treasury rate headed?
While there are many opinions centered on rates, it is recommended that investment decisions based on the direction of interest-rate movements are too challenging, and potentially too costly for prudent investors.
In order to make money timing rates, you need to accurately predict their direction (rising or falling), timing (when) and magnitude (how much). Getting any of these factors wrong can hurt your portfolio.
The Guessing Game
Every New Year, asset managers, economists and countless other pundits (including the Fed) provide economic forecasts. A majority of these experts get it wrong.
Rates have been falling, albeit in the 150 basis-point range for four years (roughly since the start of the third round of quantitative easing in September 2012). In that time, the 10-year U.S. Treasury rate has remained within roughly 150 basis points, from 3.03% in December 2013 to 1.44% in June 2016.
The 10-year U.S. Treasury yield pushed lower in 2016 by the combination of concerns about Chinese growth, negative interest rates, sluggish global growth, the Brexit vote and volatile equity markets.
Before moving out of the current range, catalysts likely need to come from stronger economic growth and/or stronger inflation prints that push the Fed into raising the federal funds rate.
Every three months, the Fed publishes a chart known as the dot plot. The chart shows where central bank officials think the fed funds rate should be over the next few years. The average dot-plot forecast for number of hikes in 2016 has been revised down from four to two.
Over the past four years, despite downward revisions, rates ended up higher than Fed predictions; so far this year, the central bank has not hiked rates.
The Fed, particularly Chair Janet Yellen, continues to reiterate that it will take a slow approach to raising interest rates, pointing to concerns about the global economy (most recently due to the Brexit vote).
The central bank seems to be closely following cues from the market, despite being “data dependent,” as it will only issue a hike with the market’s approval. For instance, the fed funds futures market priced in two hikes at the start of the year, much lower than the Fed’s forecast of four hikes. The futures market remains volatile, as it follows economic data rather than the dot plot.
Looking at economic fundamentals in the U.S., gross domestic product growth looks sluggish. This supports low rates, which are designed to foster economic growth.
On the other hand, stocks have risen, commodities have rebounded and the labor market appears healthy as wage growth has ticked up — all indicating the potential for higher inflationary pressures, which would support a potential Fed rate hike.
In analyzing technical indicators, overseas demand picks up as Japan and the eurozone institute negative-interest-rate policies. The low global government bond yields overseas, including $13 trillion that are trading at negative interest rates, make U.S. Treasury rates look cheap.
Looking at fundamentals and technicals, we see just as much data supporting higher rates as lower rates. This dynamic may suggest that the trading range of the past several years could persist.
We do know that:
- It is difficult to predict the direction and level of the 10-year U.S. Treasury rate or the federal funds rate.
- Attempts to time interest-rate movements are challenging and often costly.
- In order to make money timing rates, you need to correctly predict the direction, timing, and magnitude.
Obsessing about the direction and timing of interest-rate movements can be a distraction from more attractive ways to invest. We believe our clients are better served by an approach that evaluates the core competencies of managers and how they fit into a portfolio.
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