Commentary 10/2/2014

Interest rate forecasting is notoriously difficult, but sometimes there are conditions that make us think we can do it effectively. The Federal Reserve ("the Fed”) is going to wrap up its bond buying program soon, which should logically mean interest rates will go up. The Fed is going to remove demand from the bond markets causing bond prices to decline and interest rates to go up. At some point, probably next year, the Fed is also going to raise interest rates. It makes sense that interest rates will go up, especially when you look at how low they are. It’s tough to believe they can go much lower, so they must go higher at some point.

However, there is another side to the story. In the increasingly global economy, there are other important factors that could keep interest rates relatively low. The most important of these factors is probably the bond purchase program started by the European Central Bank (ECB). The ECB is worried about a slowing European economy and deflation. To combat this, the ECB is trying to replace ineffective fiscal policy with slightly effective monetary policy. The ECB believes, as the Fed does, that lower interest rates in the Eurozone will spur investment in the real economy. Lower interest rates mean cheaper borrowing and more spending. If this sounds familiar, it should. This is what the Fed is winding up after more than five years.

The idea works to some extent in the real economy, but the larger effects are felt in the stock and bond markets. The Fed has kept the world awash in cash, boosting both bond and equity markets. This may be why we have seen the odd phenomenon of the bond and stock markets going up and down at the same time. With the ECB taking the reins from the Fed, we may continue to see strength in the stock and bond markets. Where the Fed is reducing, albeit slightly, the amount of liquidity in dollars, the ECB is adding liquidity in Euros.

To continue the discussion of U.S. interest rates it is important to put them in perspective relative to the rest of the world. The reality is that our government bond rates are actually quite high relative to much of the rest of the developed world. At the time of writing this, ten-year U.S. Treasury bond rates are 1.5% higher than Germany’s, 1% higher than Sweden’s and 2% higher than Switzerland’s and Japan’s. U.S ten-year Treasury bond rates are similar to the rates in the UK, but they are actually a bit higher than the rates in Canada, Italy and Spain. Yes, Italy and Spain, the countries that played a prominent role in the second Euro Crisis, borrow more cheaply than the United States.

If the ECB is successful in lowering rates more, U.S. Treasury bonds become an even more attractive option than the bonds of these other nations. We are also seeing a trend of dollar strengthening relative to most other currencies. Market participants who see this trend continuing will find more value in U.S. bonds. They will see their dollar investments gaining value with higher interest rates than what they can get in most of Europe.

The headlines will read that the Fed’s actions will cause interest rates to rise and, therefore, the value of our bonds to fall. It is important to know that in this global economy, there is more to the story. We will most likely see volatility in both the stock and bond markets. However, after the dust settles, it is not a foregone conclusion that interest rates in the U.S. will be much higher than where they are now.