The Great Interest Rate Debate
It’s been said that the second law of economics states that for every economist there is an equal and opposite economist. As we noted in our commentary a few months ago, despite the perceived accuracy in building statistical models, economic analysis – unlike some of the more definitive theories in physics and chemistry – is still as much an art as a science. Former US president Harry Truman best summed up the back-and-forth tendencies of economists when he requested a “one-handed” report after his economic advisors consistently presented ones that concluded, “on the one hand, this, but on the other hand, that“.
Differences in opinion are, after all, what make markets function. Every buyer must find a willing seller, at the same price. The latest source of contention is the future path of interest rates. The chart below highlights the growing chasm between the expectations of US central bank economists and those of the private sector.
Eight times a year, the twelve members of the US Federal Open Market Committee (FOMC) get together to assess the latest economic developments. For the past six years, given the uneven growth, high unemployment and benign inflation rates throughout the developed world, the FOMC set short-term interest rates at, or near, zero percent. Much to the chagrin of global savers, major central banks – including the Bank of Canada – followed suit. It seemed as though everyone was on the same page. In an uncertain investment environment, ultra-loose monetary policy was the one constant.
However, this year marks a departure from the usual refrain. Reported economic indicators increasingly point to a global economy that is moving out of the recovery phase and into an expansionary cycle. Given this backdrop, in March the FOMC indicated that the first in a series of interest rate increases could commence in just over a year [shown in the graph by the purple squares]. A few months later, further evidence of a strengthening economy prompted the committee to accelerate its forecast for interest rate hikes [this current forecast of interest rate increases is depicted by the blue triangles]. All told, the FOMC now projects interest rates will be near 1.25% by the end of 2015.
To be sure, a 1.25% interest rate is still low relative to historical levels. The significance of this forecast stems from how much it is at odds with market expectations. Using the trading prices of financial instruments, one is able to discern the market’s consensus for the future path of interest rates. Channeling Truman’s economic advisors, investors are increasingly betting “on the other hand”. The light blue line shows the market’s outlook in March, which was well below FOMC guidance. Interestingly, despite having the same economic data, investors believe that rates will continue to be close to zero for at least another year [current expectations illustrated by the dark blue line].
Maybe this is a case of wishful thinking. Ultra-low rates have certainly contributed to the record levels recently attained in global equity markets. On the other hand, the FOMC has consistently been more optimistic about the economy. Last summer, the committee spooked investors by presenting a timetable for the end of monetary stimulus. Despite a short-term spike in rates, our commentary at the time noted that yields were likely to remain low going forward, given the soft inflation and weak growth environment. With the benefit of hindsight, this proved to be prescient.
Only time will tell whether the FOMC or the markets have the timing right. However, because predicting short-term economic or market developments is an inexact science, TEIC believes in building diversified portfolios that can perform in any scenario. Should rates rise, our allocations to short-term fixed income securities and equities should prove beneficial. On the other hand, if it’s true that rates will stay “lower for longer”, investments in higher-yielding corporate bonds and mortgage funds should help provide additional income.