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Interest Rates To Go Up?

|Includes:LNC, MetLife, Inc. (MET), SLF

The US Federal Reserve believes that the best way to control the economy is by controlling the short term rates and influencing the long term rates. In the following pages I have looked at the history of interest rates- the Fed funds rate, 1 year Treasury and 10 year Treasury rates along with inflation rates. Finally I have compared US long term rates with other countries. Looking at the history may help in understanding the relationship of interest rates with other factors. Currently there is a very strong correlation between long term interest rates and life insurance stocks.

In the accompanying graphs, I have plotted the Fed Funds rate and Consumer Price Index (NYSEARCA:CPI), 1 Year Treasury Rate and CPI for the past fifty years. The Federal Reserve looks at Core Inflation, which is the inflation excluding energy and food prices. The Fed feels that energy and food prices can be volatile on a short term basis and that it is best to exclude them. I have included CPI in the data analysis as most people in this country and around the world tracks CPI.

The Fed funds rate, 1 year Treasury Rate and Average CPI:

Source: Federal Reserve, Bureau of Economic Analysis

Looking at the data, the Fed funds rates and 1 year rate have tracked the inflation rates for most of the years. The CPI was usually higher than the core inflation. There was a strong correlation between the Fed funds rate and 1 year rate, however there were brief periods when 1 year rate was less than CPI. In the 1970s during the oil crises, average CPI was higher than the interest rates. In early 1980s the Fed intentionally increased the Fed funds to control high inflation even though it led to recession. As inflation abated, the Fed also reduced its rate. Also in 2003, the inflation rate was higher than 1 year interest rate, the Federal Reserve intentionally kept low rates, as the Fed thought there was a serious threat of deflation. The view was in Japan after the bubble, Central Bank of Japan did not do enough to prevent deflation and the Fed did not want to commit that error. However, once the consumer prices started moving up, the Fed also increased its short term rate.

Even now with high unemployment the Fed has intentionally kept the interest rates below the CPI.

When the Fed embarked on QE2, many participants in the commodity market viewed that inflation will come soon and there was a rise in the commodity prices. This increase in prices started appearing in the inflation data around the world. In response to increasing inflation, the Central Bankers around the world started tightening the monetary policy by increasing the short term rates. The effect of the increase in the rates was drop in global GDP and inflation.

Below is the comparison of 1 year and 10 year rates.

Source: Federal Reserve Bank

Historically the 1 year and the 10 year treasury rate have moved very closely. During the 1990s recession when the Fed reduced the Fed Funds rates, the 10 year did not drop as drop in 1 year interest rates as investors viewed that decrease in the rates as temporary. In late 1990s, the Federal government budget changed from being in deficit to being in surplus resulting in Federal government Debt to GDP ratio to drop. However over the last decade Federal government deficit changed from being in fiscal surplus to being in fiscal deficit resulting in Federal Government Debt to GDP ratio to increase. This increase in deficit and debt to GDP ratio has not led to increase in 10 year rates. In the middle of the decade, the 10 year rates diverged significantly from 1 year rates and the Fed funds rates. The Fed has attributed this divergence to savings glut around the world. In the past decade emerging economies have grown significantly and have intervened in foreign exchange markets by accumulating developed countries' government bonds. The Fed has also embarked on Quantitative easing and began buying government bonds. Whether this buying of government bonds has reduced interest rates, is still debated. There is a view that excess demand from investors, scared of euro currency breakup is increasing the prices of Government debt causing the drop in Treasury yields.

Below are the comparisons for 10 year Government rates for US Treasury Bonds compared with other countries. These countries have their own currency and floating exchange rates with the exception of Germany; their own central banks, different GDP growth rates, Debt to GDP rates, current and projected fiscal deficits, current account surplus or deficits, unemployment rates, short term rates, and governments over the years.

UK 10 Year Interest Rates and US 10 Year Interest Rates:

Source: Federal Reserve Bank, Bank of England

Australia 10 year Interest Rates and US 10 Year Rates:

Source: Reserve Bank of Australia and Federal Reserve Bank

10 Year Canada and 10 Year US Treasury Rate:

Source: Federal Reserve and Bank of Canada

10 Year Germany and 10 Year US Interest Rates:

Source: Bloomberg

10 Year Japan and 10 Year US

Source: Federal Reserve and Ministry of Finance, Japan

One of the key take away from the above graphs is that over the long run key 10 year interest rates on Government bonds for advanced countries are becoming more and more correlated. Despite so many differences in each country's economic metrics, interest rates have fallen. Even though central banks of developed nations differ on policy prescriptions for their economy, one of the common objectives they have is to keep inflation low. Most central banks have adopted the policy of maintaining low inflation rate (2% or less per year). Their actions have led to low inflation. This provides some explanation for synchronized downward path of interest in the past 2 decades.

Any borrower when appears to be in a weaker financial position, the creditor often requires higher interest rate to compensate for any risk that borrower may not pay. The high rate of interest that Governments in Spain and Greece have to pay is not primarily due to high Debt to GDP ratio but because it does not have its own currency. Spain and Greece shares their currency with other European countries. In case of countries loss of confidence is more likely to be reflected in the foreign exchange rates than in the interest rates. Even though Japan has high Debt to GDP ratio, interest rates have not arisen. In Japan, there have been constant warnings from many market participants that high debt will increase the interest rates, but interest rates have not risen. In US in early 1990s when the Debt to GDP was low, interest rates were high and now when the Debt to GDP is high, interest rates are low. The predominant factor for the long term rates is the inflation rates. Investors in US should focus less on the rhetoric for high Debt to GDP ratio as this ratio is unlikely to drive significant movement in interest rates in either direction.

The Fed is intentionally keeping Fed funds rate low. With inflation being higher than the nominal interest rates, investor is getting negative real interest rates. The Federal Reserve would not try to create higher inflation, as it would lose its credibility. Additionally if it actively tries to create much higher inflation, its impact will most likely be muted due to highly interconnected trade flows and capital flows between countries. If the US's inflation rate rises, it will get transmitted to other countries and other central banks will tighten their monetary policy. Now if all Central banks actively try to create higher inflation, then it is possible to get inflation everywhere, however odds of that appear to be low. Higher inflation creates political instability and all the governments in developed countries are unlikely to coordinate their actions to actively choose this policy. Therefore odds of very high inflation remain low.

Fifty year interest rate history has shown that real interest rates don't stay negative for many years. The 10 year interest rate should see upward traction when the markets starts believing that negative real interest rates cannot continue forever. Currently most of the Life Insurance stocks like Metlife (Met), Lincoln (NYSE:LNC) and Sunlife (NYSE:SLF) are quoting below book value. One of the reasons for current share price being below the book value is because these companies had sold products, with the assumption that interest rates would be normal and not ultra low. The ultra low interest rates are depressing the current and expected profits of these companies. The rise in interest rate will increase the profits of these companies and with the increase in current and expected profits, share price would rise. The downside risk is that conditions in Europe worsen and global economy further worsens. In that scenario interest rates could drop further. However in terms of risk to reward ratio, odds of increase in long term rates are higher. Therefore odds of increase in share prices of MET, LNC and SLF are higher.

Stocks: MET, LNC, SLF