“Will interest rates rise?” is a question we often get asked. More often it’s, “when will interest rates rise and, in the meantime, how do I invest for income?” Both questions are reasonable in the current low to no interest rate environment investors find themselves facing, especially those close to or in retirement. For decades one could purchase Bank Issued CDs, U.S. Treasury Bonds, and AAA-rated Municipal Bonds and, assuming a reasonable amount of savings, could potentially live comfortably from the interest received. Savers have been struggling with this issue since the Great Recession began in 2008.
With both long-term and short-term interest rates sitting near historically low levels, logic dictates an expectation for a move higher in rates. The honest answer, quite frankly, is that nobody knows exactly when interest rates will rise. What we can say with what we believe is relative certainty is that the interest rate environment will change. Change, however, will be gradual.
How Did We Get Here?
Every now and again a client will remind us about the time they walked into their bank and purchased an FDIC-insured CD with a 12% interest rate. The purchase was always made in the late 1970s or early 1980s. Do you remember the 1970s? Inflation was rampant, the economy was a wreck, and unemployment was high. The Federal Reserve Chairman (Paul Volker) was very active with policy to change the situation. The same but different than what we have been experiencing for the past five years.
Fortunately, the economy changed for the better and we entered a secular economic environment that saw interest rates gradually decline (see chart below). The result was a booming economy, gradually lower lending rates, and expanding credit for average Americans. Times were good and the saver was doing just fine.
Chart Courtesy of www.stockcharts.com. Indexes and unmanaged and you cannot invest directly in an index.
When the Great Recession began, 10-year Treasury Bonds were paying investors a yearly yield of around 4% per year. By the middle of 2012 that rate had fallen to below 1.5%, and has remained below 3% for more than two years. And now here we are trying to figure out when rates will “normalize,” if there is such a thing.
Soooo, Where are Rates Headed?
As we stated earlier, no one can tell you when interest rates will change – up or down. One can only make an educated guess as to what can happen. What our research tells us is that a new secular bear market for bonds – with higher rates and lower bond prices – appears to us to be the most likely outcome. What is not clear is the timing of the higher rate environment.
At Magellan Financial, Inc. we see three possible scenarios going forward:
Scenario #1 – Interest rates stay relatively low for a few years as the economy continues to recover, new industries begin to blossom, unemployment levels normalize, and long-term fiscal issues get resolved. Here, we would expect rates to slowly move higher than they are today, but not so high as to cause policymakers concern. At some point economic activity pushes inflation to above-trend levels, forcing rates higher. We believe this is the most likely development.
Scenario #2 – Less likely than our base case scenario, rates remain low for an extended period of time al la Japan circa 1985 to present. For this to occur, the economy would need to continue to muddle along, capital spending not rebound from current low levels, and fiscal problems do not get resolved. The result would be continued unemployment issues that weigh on the economy, causing stagnation and possibly deflation.
Scenario #3 – Here we would see an overheated interest rate environment. This assumes the economy is booming while lending/borrowing return to pre-crisis levels. Accompanying higher interest rates would most likely be an inflation rate at levels that concerns policymakers and above-trend growth rates. In our opinion, this is the outlier outcome.
Factors Affecting Interest Rates
Yes, trying to predict interest rates is a fool’s game. But it is a fool’s game in which an astute observer can make an informed decision on how a secular bear market in bonds play out over time, assuming rates don’t stagnate. There are a number of factors to be considered, some reflationary while others are deflationary. When and how interest rates move we believe will be determined by the following:
Housing Rebound – does the new housing market continue to grow or do we hit a point of stagnation? This is important for employment and GDP growth.
Restoration of Household Net Worth – The Great Recession put a huge dent in both home equity levels and the value of savings. Both have been improving. Continuation of this trend will be good for discretionary consumer spending, and thus growth of GDP.
Capital Project Resumption – With government spending curtailed at the State and local levels, many capital infrastructure projects were put on hold. Normalization in capital spending would produce jobs, add to GDP growth, and benefit society long-term.
Lower Unemployment Levels / Fed Tightening – Chairman Bernanke has been very clear about his intension to keep rates low until employment levels are back to historically normal levels. We believe that The Fed raising short-term interest rates will lead to higher rates across the interest rate spectrum.
Energy Boom – The United States is fast becoming a global leader in oil and natural gas production. We expect this trend to continue, helping produce well-paying jobs and reducing the trade deficit.
Demand in the Developed World – Unemployment is at historically high levels, budgets are tight in both the public and private sector, and consumer spending has been lacking as a result.
Deleveraging – The level of global debt remains very high and the consumer in the United States continues to shed debt.
Demographics – With the Baby Boomers entering retirement age, the long-term trend will be less people working as a percentage of society as a whole. A change in immigration policy at the Federal level could impact this trend going forward.
The Need to Save More – As more people get closer to retirement age there is more of a need to save more and spend less. This has an effect on consumer spending/demand.
Globalization/Technology – Global markets have moved basic labor to lower cost manufacturing areas while technology has enabled workers to become more productive per employee.
Bank Regulations – Basel III has forced banks to increase their capital levels while requiring a higher quality of assets. This forces reserves into higher quality assets – thus producing demand – and puts a crimp on lending.
What is an Investor to do?
The world is changing in many ways and you need to adapt your investing to the changing reality. We truly believe what worked in the past will very likely not work in the coming years. In our opinion, the days of owning AAA-rated and insured municipal bonds or U.S. Treasury Bonds for income are over. Smart investing, is about understanding the different forms of risk you are taking with different types of assets – cash, bonds, stocks – and balancing those risks to suit your personal financial situation and investing style.
Unfortunately, there is no one-size-fits-all solution to the income problem many investors face. Every situation is different and deserves a customized solution. For current clients, either call or send us an email to schedule a review. If you are not a client of Magellan Financial, Inc., we can schedule an initial consultation. We can be contacted at 610-437-5650 or via email.
If you have any questions on the materials presented or would like to be added to our email list, we can be contacted at 610-437-5650 or via email.
Past performance is no guarantee of future results. Dividends are subject to change or elimination and are not guaranteed.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Stocks offer long term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
This and/or the accompanying statistical information was prepared by or obtained from sources that Magellan Financial, Inc (Magellan Financial, Inc is a separate entity from WFAFN) believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Additional Information is available upon request.
Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), member SIPC. Magellan Financial, Inc. is a separate entity from WFAFN.