Everybody Says Higher Interest Rates Are Coming … But When and By How Much?

Art by James Yang

Rising interest rates, monstrously high at one point and absent in any form for years, are finally, finally expected to surface anew. The two questions vexing investors are 1) when and 2) by how much?

Note, though, that the increases probably won’t be much of a monster. The likely answers to those twin questions, according to investing experts: In two to three years and not radically higher than today. The catalysts for rate increases likely will be more inflation and strong economic growth. Plus, the spiraling debt loads that may impact both. 

Hovering over everything is whether the pandemic can be routed and how quickly. “What if the vaccine doesn’t work against spreading variants of the virus?” asked Marcus Dewsnap, head of fixed income strategy at Informa Global Markets. “That’s too scary to think about.” Then, rates would stay way low and so would economic growth.

Absent that nightmare scenario—and most prognosticators believe science can vanquish any of COVID-19’s shape-shifting—the conventional Wall Street wisdom is for better days ahead on both the health and the economics fronts. And since escalating rates are co-dependent on an improving economy, a sunny thesis appears pretty solid.

Historically speaking, low rates like today’s are an aberration. Thus, at some point, it’s reasonable to assume they will return to normal. Or at least to higher than now, to a degree. A new normal that’s hardly towering.

Let’s look at the two main US fixed-income benchmarks, the Federal Reserve-set short-term rate (aka, the federal funds rate) and the market-determined 10-year Treasury note’s yield. Time was, they were much higher than currently. In 1995, a decent year for the US economy (growing 2.7%), the short-term benchmark was 5.5% and the T-note was 7.8%. That’s quite a contrast to recession-ridden 2021, when the federal funds rate is near zero and the 10-year is 1.14%.

How Low Can You Go?

Federal Reserve policy, echoed by other major nations’ central banks, is to keep short-term rates very low for the next two to three years. That policy has spilled over to longer-term fixed-income securities. But this still leaves the US with a very helpful advantage. Relative to other major nations, the 10-year Treasury offers the best yield, exceeded only by the payout for Australia’s equivalent bond. Of course, Australia’s bond float is far lower: Its economy is a mere 6% of the US’s.

Compared with the economic growth in the US, Europe’s and Japan’s expansions in recent years have been inferior. Hence, their 10-year sovereigns offer yields below 1% and, in the case of France and Germany, are negative. This situation makes the T-note more attractive, and that has been key to attracting foreign funding for the US’s burgeoning federal debt.

The U.S. Has Few Peers in a World of Low Interest Rates—Relatively Speaking (10-Year Government Bond Yield)

Australia

U.S.

Canada

1.24%

1.14%

0.96%

U.K.

Japan

0.44%

France

Germany

0.06%

-0.23%

-0.45%

Australia

U.S.

Canada

1.24%

1.14%

0.96%

U.K.

Japan

0.44%

France

Germany

0.06%

-0.23%

-0.45%

Australia

U.S.

Canada

1.24%

1.14%

0.96%

U.K.

Japan

0.44%

France

Germany

0.06%

-0.23%

-0.45%

Australia

U.S.

Canada

1.24%

1.14%

0.96%

U.K.

Japan

0.44%

France

Germany

0.06%

-0.23%

-0.45%

Source: Dow Jones, Bank of Canada, as of February 5, 2021

The estimates of the Fed’s policymaking committee members—in a survey known as the dot plots—are that the federal funds rate will stay at the same level, near zero, through 2023, and rise eventually for the long run to 2.5%. They don’t spell out what the timespan for that 2.5% is.

The thinking is that, by 2023, the plague will be over and the economy back in the groove. “Two years from now, post-corona, people will feel they can leave their houses without dying,” said Frank Rybinski, chief macro strategist at Aegon Asset Management.

Few believe that, absent some unforeseen and unlikely event like a return to 1970s-style double-digit inflation, rates will move up to anything on the order of 1995’s numbers. One theory is that people are so conditioned to low rates that they won’t accept large orders of magnitude above the current points.

This sentiment has been around for a while. The market got a first  taste of low, low rates  in the aftermath of the 2001 recession. They crept back up to mid-single digits in the middle of the aughts, then plummeted as a result of the 2008-09 financial crisis. Ever since then, the very idea of jacking up rates has run into stalwart opposition.

During the 2013 “taper tantrum,” when the Federal Reserve suggested it might reduce its bond purchases (a tool to keep long-term rates down), there was a large sell-off. Yields for 10-year Treasuries, which move in the opposite direction from prices, surged 1.5 percentage points, to 3.3%. The Fed quickly squelched talk of reducing bond buying, a procedure known as quantitative easing, or QE.

Similar pushback happened when the Fed gradually began escalating the fed funds rate, starting in 2015. The Fed came under heavy criticism from a re-election-minded President Donald Trump and many Wall Street figures. In 2019, the Fed backed down and reversed its tightening campaign.

When the Fed does ease off its crusade to bolster the economy, the common prediction is that the process will be gradual. “They’re not saying when they are going to stop” with QE, said George Mokrzan, senior economist at Huntington National Bank.

And, as Fed Chairman Jerome Powell is fond of saying, any decision on increasing rates will be data-driven, taking economic growth into account before moving.

“Fed policy here is like driving,” said Kelly Ye, director of research at IndexIQ. “It depends on the road conditions.”

The historical average yield for the 10-year Treasury is 4.5%, said Scott Colyer, CEO of Advisors Asset Management. Will that level come again, as bonds revert to the mean? Current trends militate against it. The highest the T-note has gone this century is 6.5% in early 2000. Since then, it has been well south of 6.5%, and hasn't been above 4.5% since before the Great Recession. Reaching 4.5% again “won’t happen in my lifetime,” Colyer stated.

Higher interest rates have a wide-ranging effect. They can pinch share prices, as better-paying bonds wean more investors from stocks. On the other hand, higher inflation—which usually accompanies rate rises—often means the economy is expanding nicely. And that is an accelerant for equities.

This phenomenon is something pension chiefs watch carefully, as it affects their ability to pay retiree benefits now and in the years ahead. Susan Ridlen, CIO at pharma company Eli Lilly, has a strong position in stocks. And she believes higher rates would “be favorable to growth assets over the long term.” Longer term bonds’ yields will “creep and bounce” over the next year, she said, and all the Washington stimulus will bring some inflation eventually two to three years in the future.

Why Rates Would Rise

So here’s a look at what three forces at some point will hoist interest rates aloft, even if it’s by less than historical norms:

Inflation. Price hikes have been in the low single digits for the last quarter-century. Chief reasons: globalization, automation, and digital commerce. The latest Consumer Price Index (CPI) increase is far from the 2% level that the Fed wants to see before hiking short-term rates. Last year, the inflation index increased just 1.4%. Or using the Fed’s preferred metric, known as Personal Consumption Expenditures, 1.2%.

Market expectations for slightly higher inflation are on the upswing, although they’re not showing any radical increases. The 10-year breakeven point for Treasury inflation-protected securities (TIPS), which measures what the market expects inflation to be over the next decade, was 1.2% annually at mid-year 2020, and now is 2.2%.

A few signals have appeared about rising inflation. “We see spot indications in commodities,” said Bruce Monrad, chairman of Northeast Investors Trust. Oil, copper, and rice are among the commodities that have seen price boosts since the lows of last spring, as expectations mount for a meaningful economic recovery. Real estate and stocks also have been on a tear.

Assuming the effectiveness of the vaccines, many observers are looking for a surge in pent-up consumer spending in 2021’s second half, noted Duke Laflamme, CIO of Eaton Vance WaterOak Advisors. The rush to spend, however, “should be temporary,” he cautioned.

Regardless, people will have a bunch of money to deploy for bidding up the costs of goods and services. An enormous swelling in liquidity has occurred, as the Fed and the federal government pumped aid into the limping economy.

Congress and the Trump administration first injected almost $2 trillion into the system last spring, followed with another $900 billion in December. The Biden administration is aiming to add another $1.9 trillion. The nation’s money supply, as measured by the M1 metric, has expanded to $7 trillion from $4 trillion pre-pandemic.

Economic Growth. Last year, US gross domestic product (GDP) shrank 3.5%, after a 2% rise in 2019. “We’re still in a recession,” Aegon’s Rybinski said. The typical slump features major pain in the manufacturing segment and less in services. The current downturn has switched that order. What’s needed for a vibrant economy is a vanquishing of the virus for people to once again go to restaurants, the movies, and on trips, he added.

As always, more optimistic economic psychology is vital for any true recovery. “The economy needs to be stable, and it’s fragile now,” Informa’s Dewsnap said. Continued fragility, he warned, means “companies won’t want to expand.” In the wake of the financial crisis a decade ago, many businesses and consumers were leery about opening their wallets. C-suite caution is still around.

The hope nowadays, and this is not an unreasonable one, is that the vast enlargement of savings and the gradual comeback of economic activity are setting the stage for a strong boost to GDP with staying power. Forecasts are for a bigger-than-usual GDP expansion and range from 4% to 6% for 2021. In the meantime, Treasury Secretary Janet Yellen has declared that the nation faces “some tough months ahead” to get to that happy place.

Should a robust economic jump take place, wrote Bank of America economist Michelle Meyer, then the Fed can begin raising rates by the end of 2023. “This clearly would be an exceptional outcome,” she contended. “If all goes as planned, Chair Powell and Yellen will be able to take a bow.”

Macro Debt Shifts. In early March, right before the pandemic spooked investors and led to lockdowns, the Fed’s balance sheet was just $4.3 trillion. With the onset of the massive boost in Fed bond buying, aimed at keeping long rates low, the ledger ballooned to $7 trillion. In its QE campaign, the central bank is buying $80 billion in Treasury bonds and $40 billion in agency mortgage-backed securities (MBS) monthly.

Meanwhile, the federal government’s debt has soared since the 2008 financial crisis, by some $15 trillion. Of course, there’s an argument that Washington’s borrowing has been offset by a reduction in household debt, as shut-in Americans became more thrifty. The ratio of federal debt to GDP has climbed to over 100% from 50%, while private debt’s ratio dipped to 240% from 290%, counterbalancing the public debt engorgement. At the same time, the cost of serving government debt has plummeted due to lower rates. It’s now 2%, as opposed to 4% in the 1990s.

The Fed likely will taper its QE purchases before amping up short-term rates, observers say. “Tapering will enter the conversation at the end of 2021,” Rybinski predicted. Since QE is focused more on shorter-term paper, some of the Fed’s holdings would simply roll off on their own as they mature, instead of getting reinvested, which is the practice now..

The amount of federal spending is another issue because President Joe Biden wants to increase it to address needs other than the pandemic recession, such as repairing America’s crumbling infrastructure. Unless the GOP assumes control of Congress again in the midterm elections, taking over at least one of the two chambers, Washington’s outlays will be an inflationary force—and that betokens higher rates.

Nonetheless, if current conventional wisdom plays out, the new rates should not be onerous.

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