Interest Rate Direction is Hard to Peg

Following is an article by ING Investment Management pertaining to the direction of interest rates. While there is extensive talk of inflation, the recession risk is still high according to most economists.

Interest Rates: Are They Headed Higher? Or Lower?
by Pierre Couture, A.S.A., E.A., M.A.A.A., Vice President and Senior Actuary

Earlier this year (April 21, 2008) I wrote an article here concluding that unless someone had very strong views about future bond yields, a long duration strategy should be implemented in stages (i.e., dollar-cost averaging). The main rationale was that it is very difficult to predict when and at what speed real yields, break-even inflation rates, and Aa-rated corporate bond yield spreads move toward their long-term averages across several maturity points.

Most people that I have spoken with since I wrote that article think that interest rates are more likely to rise than to fall in the future and, as a result, are waiting to implement a long duration strategy. Below are data points that may cause some of them to reconsider their views.

 

S&P 500 Price Index vs. 10-Year Treasury Bond Yields

This heightened concern about inflation has led many investors to believe that we have entered a stagflation economic environment, i.e., low economic growth with rising inflation/interest rates. It looked to be the case from mid-May 2008 to mid-June 2008 as the S&P 500 Price Index fell while the yield on 10-year Treasury bonds increased. However, since then, both the 10-year Treasury Bond Yield Index and the S&P 500 Index have been falling, which is looking more and more like a recessionary environment that could dampen the inflationary threat.

Interest Rate Forecasts from Economists

According to The Wall Street Journal on July 10, 2008, economists are deeply divided over whether the Federal Reserve should focus more on economic growth vs. inflation. Of the 53 economists surveyed, 22 said the Fed should be more concerned about economic growth, while 21 said that the main concern should be inflation. The rest said the risks were equally balanced, or declined to answer.

Let’s compare the interest rate forecasts from three groups of economists. All three forecasts show that the Federal funds rate will fall from 2.00% currently to 1.50% by June 30, 2009, and that the 10-year Treasury yield should be around 3.5% by the end of this year. However, their views diverge with respect to where they see the 10-year Treasury rate by the middle of next year. None of the three sees a big increase in interest rates, and in fact, their numbers seem to indicate a view that interest rates will be lower except for the 10-year interest rate forecast from ING Wholesale Banking.

Economists, Almost in Harmony, Sing From the Same Sheet of Music

Corporate Bond Yield Spreads
A very big unknown is how corporate bond yield spreads will behave over the next several months. A low economic growth environment will make the credit crunch last longer, keeping corporate bond spreads high. The spreads of very high quality corporate bonds have started to rise again after falling during April and May of this year.

Spreads Widen Out Again On A Discouraging Economic Outlook

Conclusion

Being able to predict future interest rates requires the ability to forecast inflation rates and economic growth, over both short-term and longer-term time frames. But how much inflation fears may be dampened by the threat of a recession in the current economic environment makes interest rate forecasting more difficult than ever…just ask the Federal Reserve!