This area, to me, is the most difficult subject to speculate about in 2015. Maybe because it was the area that I got really burned on in 2014.
I expected longer-term interest rates in the United States to rise…and fairly substantially. Well, it didn't happen.
First of all, I thought the growth rate in the United States would be in the 3.0 percent to 3.5 percent range. Furthermore, I thought that with the recovery in Europe I expected in 2014, that more and more of the "risk averse" funds that had been funneled to the United States during the previous couple of years would flow back to the eurozone and this combined with faster U. S growth would result in a fairly strong rise in the "real" rate of interest in the United States.
Well, year-over-year, in the United States in the third quarter of 2014, the growth rate was only 2.7 percent and the economies in the eurozone did not do too well and there was a growing fear of deflation on the continent.
The "real" rate of interest in the United States did not rise. If one uses the yield on the 10-year U. S. Treasury Inflation Protected securities (TIPS) as a "proxy" for the "real" rate of interest, then the "real" rate of interest declined. At the end of 2013, the yield on the 10-year TIPs was around 0.770 percent. Currently, the yield on the 10-year TIPs is around 0.550 percent, and that is higher than the yield has been since the end of September.
Second, inflationary expectations, which I thought would rise in 2014, also fell in 2014. The inflationary expectations built into the yield on the 10-year Treasury note were around 2.20 percent at the end of 2013; it is currently around 1.70 percent.
The yield on the 10-year Treasury note was just below 3.00 percent at the end of 2013, and, it is around 2.25 now…a drop of approximately 75 basis points.
Bottom line: a pretty bad forecast.
One other thing I would like to add to these two points: I believe that is has become more and more obvious throughout last year, but, also over the past two- to three-years, just how interconnected global financial markets are. During this time we saw tremendous movements of funds throughout the world as investors went "risk-off" and "risk-on" and moved funds accordingly.
In addition, it has amazed me just how much of the largesse of the Federal Reserve has flown throughout the world. Three rounds of quantitative easing have spread dollars far and near and it is unclear just how these funds benefited, not only the United States, but the rest of the world. If you have read any of my monthly reviews of the US banking system you will have some idea of how the Fed's efforts spread through American banks, but also offshore through "foreign-related institutions."
So, this is the environment we move into 2015
First off, in terms of economic growth: I have argued that the United States economy will only grow in the 2.6 percent to 3.0 percent range in 2015. Over the past five and one-half years, the period of economic recovery, the US economy has grown at a compound rate of growth of only 2.3 percent. In the third quarter of 2014, the economy only grew at a 2.7 percent, year-over-year rate of growth.
Thus, I would expect that the "real" rate of interest in the United States should rise. The "proxy" of the "real" rate, the yield on the 10-year TIPs might return to the 0.70 percent to 0.90 percent range, but I don't think that it will rise much higher than this.
The reason keeping this forecast so low? Here I go back into a global focus. Analysts have marveled that the demand for TIPs have remained so strong, especially since inflationary expectations in the United States…and the world…have dropped so sharply in 2014. And, the expectations for slow global economic growth and low rates of inflation, even deflation, for 2015, have seemingly resulted in a lot of "global" investors putting their funds into the TIPs market. I think that this underlying uncertainty will continue into the new year.
Furthermore, as I alluded to in other posts, there are a lot of areas in the world that could provide "shocks" to global markets. In terms of the decline in oil prices, Venezuela appears to be ready to collapse, while Iran and Russia are also mentioned in this space. The rise in the value of the US dollar has placed other countries at economic risk because it just seems to change the whole world order. And, then there is the Middle East…. There seem to be plenty of areas where things could fall apart. If any of these "shocks" occur, then the yield on the 10-year TIPs may fall below the range I presented just above.
Now, let's move into the area of inflationary expectations. Because three rounds of quantitative easing on the part of the Federal Reserve have resulted in a huge amount of excess reserves existing in the banking system, many analysts have expected that at some time rapid inflation will break out in the United States.
Yet, currently officials at the Federal Reserve, among others, do not see inflation in the United States returning to the Fed's target rate of 2.0 percent until at least 2017…or beyond. The 1.70 percent inflationary expectations market investors have built into the yield on the 10-year US Treasury note, is the expected compound rate of growth for this period. The inflationary expectations built into the 5-year yield, has currently been around 1.50 percent. Thus, expected inflation for five-to-ten years out doesn't reach the Fed's target of 2.0 percent.
Now, introduce global markets. I wrote of the fact that some in the eurozone are expecting the area to move into a period of deflation…not unlike Japan. The yield on the 10-year German bund is around 0.60 percent, right around where the yield on the 10-year TIPs resides. And, can you believe that the yield on the 10-year French government bond is below 0.90 percent, 140 basis points below the yield on the 10-year US Treasury note. And, the yield on the Canadian bond is below 2.00 percent. And, so is the Italian security below 2.00 percent, where Italy is in its third recession in the last six years.
Inflationary expectations in the world are very, very low.
So, what does this mean for the yield on the 10-year US Treasury note? Well, if the economy grows in the range I expect it to grow at, and if inflationary expectations don't pick up at all in 2015, and if the world avoids the "shocks" I have discussed earlier, then I would expect the yield on the 10-year Treasury to rise somewhat from where it is now…but, not by too much.
Let me say that the yield on the 10-year Treasury should rise and run in the 2.50 percent to 2.90 percent range in the next year.
As I have written in my regular posts on the current actions of the Federal Reserve, I believe that the Fed is "cautiously" attempting to reduce the amount of excess reserves in the banking system so that as the economy continues to expand, the money markets will become "less loose." This will allow the Fed to assist an increase in short-term interest rates, and, as this happens, there will be a little spill over into the longer-term end of the market that will put a little more pressure on a rise in the longer-term rates.
However, if one of the shocks mentioned above hits the world, the US dollar will become a haven for "risk averse" funds again.
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.