Why U.S. Interest Rates Won't Rise

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 |  Includes: TLT
by: Mary Gates

Summary

Investors should buy Treasury bonds such as the TLT exchange traded fund.

US interest rates are headed lower due to the end of QE.

The end of Quantitative Easing will lead to a rotation from stocks into bonds.

Many investors and traders in the marketplace have been puzzled as to why US interest-rates have fallen since the beginning of 2014. The marketplace for interest-rate risk has changed significantly since the crisis of 2007-08 and it seems investors and traders have failed to take that into consideration in betting on higher interest rates. The most significant and obvious change to the marketplace is the Federal Reserve's quantitative easing (QE) program.

It is understandable that some investors have inaccurately predicted the impact of the Federal Reserve on the US interest-rate market, since the quantitative easing program is unprecedented. Market participants generally use past data observations to extrapolate where US interest rates might go into the future. In the case of US interest rates, trader models, intuition and market pulse have provided the wrong signals and I believe the following reasons provide a partial explanation as to why traders and investors betting on higher interest rates have been wrong and will continue to be frustrated betting on higher US interest rates.

First, the rebound in the US economy has led to higher tax revenues for federal, state and local governments. This has reduced the amount of US debt issuance at about the same rate quantitative easing is being scaled back. So, in terms of supply / demand dynamics, we are left with a roughly neutral impact on US interest rate levels. Many traders and investors betting on higher interest rates usually lean on the argument that since the end of QE will lead to less demand due to reduced Federal Reserve govt bond buying, that it must follow by a simple supply / demand argument, that interest rates must rise to reach a new equilibrium level and clear the market. But as we stated above, the US govt is reducing issuance at the same time, therefore, the supply demand argument for higher interest rates is not compelling.

In a normal market environment where the Federal Reserve is not purchasing US Treasury bonds, longer dated interest rates have a higher interest rate risk premia embedded in interest rate yields, meaning investors are being compensated for the risk that interest rates may be significantly higher in the future exposing current long bond investors to losses. Indeed, this interest rate risk premia is one of the main reasons yield curves tend to slope upwards. The Fed's QE program has been highly effective in reducing that risk premia. In fact, that has been the main channel in which the Fed's program has been used to reduce longer term interest rates. Many believe this process will reverse and argue that long dated interest rates will rise due to rising interest rate risk premia after the Fed ends their QE program. However, I don't think it is likely.

Interest rate risk premia is closely tied to interest rate volatility, which is likely to remain low even after the Federal Reserve exits QE. Recent history suggests a positive relationship between interest rate levels and the rate of expansion of the Fed balance sheet. As the Fed reduces the pace of bond buying, interest rates tend to decline, a counter intuitive result and not what most people would bet on.

This happens due to investors growing less comfortable with risk, due to less Federal Reserve market support, and shifting portfolios from riskier assets back into US Treasury bonds. During this process, inflation expectations, which drive interest rate volatility and interest rate risk premia, stay anchored or even move lower as investors fear a disinflation scenario due to less Federal Reserve market support.

Experience with previous QE programs suggests that when the Fed reduces bond purchases, investors respond by rotating into US Treasury bonds at a greater rate than the Federal Reserve reduces US bond purchases, which through simple supply / demand dynamics, pushes interest rates lower. Many investors seem to believe that as the Fed steps away from the bond market through reduced purchases, that traders and investors will not step in to replace the Fed's purchases. However, that argument is not supported by recent evidence.

Therefore, US Treasury bonds offer attractive value at current rate levels. They offer portfolio diversification benefits, positive carry and I believe strong potential for capital gains as the Federal Reserve winds down QE. In the upcoming months, we are likely to see investors shift away from equities and move back into bonds as QE is removed from the marketplace. With the S&P currently trading near all time highs and credit spreads at historically tight levels to US Treasury bonds, I believe investor portfolio rotation will outweigh the rising risk premia, and once again be the dominant factor in leading to lower yields. Investors and traders should buy long dated US Treasury bonds or treasury etf's such as TLT to capitalize on portfolio reallocations that appear to be already underway.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.