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Once Upon a Time, When Interest Rates Were Above Zero...

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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

 

Once upon a time, when interest rates used to be above zero…

The beginning of 2018 marked a brief time period in Interest Rate Land. Interest rates along the U.S. Treasury yield curve were inching higher. As the benchmark 10-year yield was manifesting itself above 3.0%, quickly trend-following bond experts began predicting. The 10-yr. should reach 4.0% fairly soon.

Economists rarely get a chance to use the phrase ‘…I told you so…’ That might have something to do with our dismal record of 5 out of 3 Economists predicting the last recession. But Zacks Economists remained apprehensive of that prediction. We continued to predict that the 10-year would remain below but close to 3.0%.

We did not get the recent decline right. But the reasoning behind our prediction remains the same. That is, we do not foresee rates inching higher anywhere near-term (aka in Q4-2019). Rather, expect the trend depicted in the graph below to persist.

 

Exclude an unusual period in the 80s, where strong inflationary pressures (driven largely by external events like an Arab oil embargo) caused Fed Chairman Paul Volcker to increase short term rates. From there, any bond trader can observe a clear downward trend of interest rates across all maturities towards current levels.

Notice this too: Short-term rate fluctuations appear highly insignificant in the grand scheme of things.

In fact, this downward trend was so strong that we reached not only the lower bound of zero for short-term rates during the financial crisis, but in some cases such as Europe, we even ventured into unchartered below zero rates territory. For example, homebuyers in Denmark faced negative interest rates in September.

In our view, this raises an important question: Are risk-free U.S. interest rates across all maturities soon going to reach near zero levels and remain there for the foreseeable future? What role would remain for the Fed’s fine tuning of the U.S. economy through interest rates setting?

In our view, the answers will be driven (surprise!) by the interaction of supply and demand for capital.

The downward trend in the Treasury rates graph (on the previous page) can be interpreted as a reflection of the overall development of Western economies. A prolonged period without violent conflicts in the Western world since the World War II has provided ample opportunities for capital to grow and accumulate without being destroyed during conflicts.

Subsequently, the demand for capital is becoming more and more subdued.

In particular, the period since the financial crisis has been characterized by massive provisions of capital to the market. Access to cheap capital appears to be the least of the problem of corporations.

You can see in the next graph: Nonfinancial corporate business; debt securities and loans.

Corporate leverage is at an all-time high -- with capital abundant for such an extended period of time.

 

It remains unlikely, in our view. A lower Fed Funds rate won’t be effective in unleashing a new wave of corporate investment.

The fairly sluggish investment climate seen in fall 2019 is driven by continued high levels of business uncertainty – centered on volatility in U.S. China trade negotiations, but not exclusive to them.

Meanwhile, on the supply side of the equation, the Fed’s behavior appears to be driven to continue the trend of the past. They provide more and more liquidity to the markets. Given the low amount of core consumer inflation, there appears to be no downside, any economist could argue.

But the group most hurt by this long-term development will be investors focused on fixed income as opposed to equities. These are the most risk-averse investors, such as pension funds and retirees. In our expectation, this asset allocation development appears to us to be the most likely one.

However, short-term and long-term, keep being a believer in a diversified allocation of assets. Volatility and timing are everything. A rational consensus usually gets the turns wrong.

 

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