by Brad Houle, CFA
Executive Vice President
At the beginning of the year, we stated our belief that interest rates would gradually rise as three things occurred in 2014: the economy gains strength, unemployment continues to drop and bond market investors anticipate the Fed raising short-term interest rates. Thus far in 2014, the bond market has not been aligned with Ferguson Wellman's interest rate forecast. We continue to look for signs that our thesis was off-the-mark, but the fundamentals that lead us to this conclusion remain.
After a rough start to the year that was attributed to extreme winter weather, we believe the gross domestic product (GDP) growth can exceed 3 percent without making any heroic assumptions. In 2013, there was significant fiscal drag as government cut spending. This year, the drag of government cuts should roll off and government spending will be additive to GDP growth. Unemployment continues to move downward with the most recent reading being 6.3 percent. In addition, the “wealth effect” of last year's strong stock and real estate returns should add to consumer spending which comprises two-thirds of the economy. With the aforementioned set of economic circumstances, a 10-year Treasury over 3 percent by year-end is not out of the realm of possibilities.
It is difficult to pinpoint reasons that interest rates have continued to drop this year. Theories include the potential for quantitative easing in Europe, short covering by traders and perceived slowdown in economic growth. Addressing these topics independently, there is thought that the European Central Bank will engage in aggressive quantitative easing similar to what we’ve seen in the U.S. and Japan recently. In other words, the Federal Reserve in the U.S. is buying much of the bond issuance from the U.S. Treasury in an attempt to keep interest rates low. Bonds of developed market countries in the European Union have had strong price performance since the recent debt crisis whereby the yields on Spanish and Italian bonds are not that different than U.S. Treasury bonds. The U.S. has far higher credit quality than these European countries; one can understand investor preference in owing U.S. Treasuries over European country debt.
Short covering is the unwinding of a position by an investor which is designed to gain in value when interest rates climb. Many investors have positions that are bearish “bets” on U.S. interest rates. As rates have declined this year and have not climbed as anticipated these investments lose value. Then as investors unwind these types of trades, it can cause upward pressure on bond prices which correspondingly moves interest rates lower.
Lastly, belief in slower economic data would also potentially cause interest rates to drop because it would signal a slowing economy and a delay in the Fed raising short-term interest rates. Most recently, a disappointing retail sales report for the month of April was cited by some as evidence that the economy is slowing.
We believe that the recent movement in interest rates is mostly a short-term phenomenon. The economic recovery has solid momentum and as a result interest rates should move higher slowly over time. Presently, we are underweight fixed income for our clients and have invested the accounts defensively as a result of our interest rate forecast.
Our Takeaways for the Week
o We still believe interest rates will move higher throughout the remainder of 2014
o The U.S. economy is gaining momentum during the second quarter