Global outlook for interest rates

Morningstar's director of economic analysis forecasts that interest rates will be higher by 3.5 to 4% in 2015.

Ashley Redmond 15 September, 2014 | 5:00PM Robert Johnson, CFA

 

 

Ashley Redmond: I'm Ashley Redmond for Morningstar.ca, and it's Fixed Income Week here at Morningstar Canada. We're kicking things off by talking about one of the most important elements of fixed income and that's interest rates.

For years bond investors have been waiting for interest rates to go up and they simply haven't. Right now, many investors don't know what to do with the fixed income portion of their portfolio after enjoying years of low interest rates and consistently high returns. I'm on the line with our Director of Economic Analysis, Bob Johnson, to provide some insight on the topic.

Bob, thanks so much for joining me.

Bob Johnson: Great to be here today.

Redmond: Bob, what happened with the Federal Reserve and interest rates this year?

Johnson: Well, let's start with the Federal Reserve. What they've been doing is tapering their purchases of Treasury bonds and mortgage bonds, which they were doing in an attempt to bring down long-term interest rates to encourage growth in the economy, especially housing.

The part of the program that they were in this year was the $85 billion worth of purchases, about half mortgages and half longer-dated Treasuries; and that $85 billion a month program is now rapidly coming to an end. It's expected that there will be no further buying after October. So, the Fed has begun to wind that down.

On the other hand, so far the Fed has not done anything to increase interest rates directly. All they have done is slowed their purchases of bonds. So, that's where the Fed is at.

In terms of interest rates in general—2014 has been a big surprise for most of us. Most of us thought rates would go up. The 10-year Treasury here in the U.S. was about 3% at the beginning of the year and we all thought it would go up from there. Paradoxically, despite the Fed taming its bond purchases, rates actually went down primarily because of the situation in Europe. We can talk about that later, but rates now in the U.S. on the 10-year Treasury are running at about 2.4%, still off of their bottoms which were well under 2%, but still not where we thought they might be.

Redmond: When is the next Fed meeting and what are you expecting?

Johnson: The next Fed meeting is on September 17th and it will be one of the bigger meetings. There will be a full press conference after the announcement and it's also the one that includes the Fed forecasts, which are important. That doesn't happen at every meeting or in every month. So, this is a relatively crucial period.

On the other hand, I'm not expecting much change out of the Fed. I think they will announce that the mortgage buyback program is over officially. And I think that they'll probably still play it very loose and say, depending on a broad range of economic indicators, we will judge whether the economy is strong enough to endure stronger interest rates or not. And I don't think they're going to tell us that rates are going higher or lower at this particular meeting. I think the meeting may turn out to be kind of a non-event.

Redmond: Okay. Here in Canada our rates follow the U.S.'s pretty closely. So what are you expecting for Canada's interest rates in the near future?

Johnson: I mean there has always been a great correlation because we're both very important trade partners to each other. And as the U.S. economy grows, generally so does the Canadian economy, especially in the eastern part of Canada where it's very tied to our auto industry and that's been doing well.

But the Canadian governor seemed to indicate that they're going to tread their own separate path. Some of the rates have come up a little bit in Canada. They're running higher than the U.S. already. They're running about 1% in Canada. We're running at 0% to 0.25% in the U.S. So, they're claiming that they've got a little bit of a head start and the Fed can raise for a little bit of time before Canada is going to feel any pressure to do the same.

I think that the Canadian economy has been just a little bit stronger than people thought in the most recent quarter and inflation is running right around 2%. So, I think that that there is potential for Canada to raise the rates also, but again I don't think it is [likely to] happen until sometime in 2015.

Redmond: Okay. Let's hop across the pond and tackle a pretty big topic here, Europe. What are we expecting from Europe in the near future?

Johnson: Well, as I mentioned Europe is really what's driven interest rates down over the last six to eight months and that’s because their economy has been a little bit slower in recovering than we all thought. Their recession officially ended in June 2013, and we had a couple of improving quarters, three to be exact, and now in the June quarter, we saw absolutely no growth out of the Eurozone.

Europe Central Bank has talked about quantitative easing. They've actually reduced a few rates here and there. Right now, bond rates in anticipation of quantitative easing—that is the buying of longer-term bonds—they've driven interest rates down throughout Europe. Now, some of the southern countries like Italy and Spain are seeing interest rates on their 10-year Treasuries, that aren't all that much different than those here in the U.Ss. That’s truly surprising and it’s one of the things that held back U.S. interest rates and [a reason] why they've dropped so far this year.

Redmond: Bob, what's your overall forecast for interest rates in 2015?

Johnson: I think interest rates will be higher in 2015. There is the issue of exactly when they will move higher, but indeed I think they will move higher and that rates have indeed been suppressed. Generally interest rates trade at a small premium to inflation and that would suggest that the 10-year Treasury should be trading somewhere in the 3.5% to 4% range.

However, I don't think we're going to get there in 2015. And if we do, that will be kind of the top of this interest rate move. I think with economic growth throughout the world being relatively slow as the weight of demographics and slower birthrates hit the whole economy; not just in the U.S., but in Europe, we've already it seen in Japan and now even in China. That slower growth is likely to hold down the overall rate of growth and the overall rate of interest increases.

I don't think we're moving back to a 1970’s period, when we had huge favourable demographics for growth and we had a very liberal fiscal policy. Today, they are all very tight. I think that interest rates in general will not be nearly as high as they were in the '70s and '80s [and we won’t] have a big ramp-up that absolutely destroys the bond market. I think we're more likely to have a one-time pop up, something that looks like 3.5% to 4% on our 10-year, but then things will flatten out. We aren't going to 5% or 6% interest rates. In fact, we may be lucky to hit 4% this cycle.

Redmond: Thanks for joining me, Bob.

Johnson: Great to be here today.

Redmond: For more on our Fixed Income Theme Week, visit the homepage of Morningstar.ca.

 

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Ashley Redmond

Ashley Redmond  Ashley Redmond is a Vancouver-based freelance writer.