Interest Rates as of 8/29/2014, www.oppenheimerfunds.com
Recently we have seen the S&P 500 cross 2000 points, the Dow Jones at record highs, and domestic GDP at 4.2%. Typically all signaling a strong risk-on environment. If I had been in the dark to interest rates year to date, this data alone would make me think that the 10 year treasury rate would be above 3%, not near 2%.
Normally as interest in risk-on assets grow (equities) money moves out of fixed income investments driving rates up on reduced demand. Conversely as people become more concerned with equity markets for whatever reason they will move to risk-off assets, historically fixed income, driving up price on increased demand.
Since 1982 interest rates on the 10 year treasury have steadily fallen. Last May marked the low point for the 10 year treasury rate and what many believed was the end of the 31 year bull-run for fixed income vehicles. So, why over a year later are we sitting approximately 60 basis points above the all-time low?
Some of the most notable causes for the current rate environment can be explained by geo-political tensions across the globe. Those can cause risk off investing while equities have good a reason to be increasing in value, i.e. earnings and revenue.
Another, less obvious reason for subdued rates domestically would be the inherent relationship between the rates on the above chart. Fixed income investing rewards risk with a higher interest rate. US Treasury rates are currently working within a narrow band, between the German 10 year Bund and Investment Grade Corporate Bonds. As Germany continues to struggle with stagnant prices, economic sanctions on Russia, and production issues throughout much of the EU, their interest rate has fallen substantially. Many believe that from a qualitative stand point this is why the US Treasury has not deviated to a higher rate (staying competitive for a similar level of quality).
The long-term impact of this is an eventual rate correction. When this occurs, it could be normalization of investor’s risk-on appetite. However there is a risk that that a sharp increase in rates could call leveraged investors to make a quick move to cash due to increased investing costs, causing a sell-off. Another risk would be that easy money, due to continued low rates, leads to runaway inflation and an over-heating of our economy. The Federal Reserve is watching this very issue in an attempt to avoid it… Timing is everything.
Domestic Data
The week brought generally strong domestic data:
– New home sales fell 2.4% month over month in July
– S&P/CS Home Price Index, Composite – 20 city rose 8.1% year over year in June
– CB Consumer Confidence rose to 92.4 in August, a 7 year high
– GDP for Q2 was revised from 4% to 4.2% annualized
– Core PCE (the FRB’s preferred measure of inflation) came in at 1.5% year over year for July[1]
While much of the data was good, new home sales and home values took a step back. By many this is viewed as a normalization of the market, preventing it from becoming a bubble. Also, since interest rates remain low, a slowdown in price growth only makes the current market even more appealing to buyers.
International Data
The Eurozone continues to battle deflation concerns, as it posted a 0.3% consumer price index year over year in July[2]. Business confidence measures in Spain, Germany, and Italy all fell last week; likely as a result of increasing deflation concerns, heightened tensions in Ukraine, as well at stagnant job growth in much of the region. European Central Bank President, Mario Draghi, spoke late on Friday the 22nd making further indication of a bond buying program to support the European economy.
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[1] www.mfs.com
[2] www.investing.com