written by Michael Clark, Phil Gorgone, and Ryan McGlothlin
Over the last few years, we’ve periodically taken a closer look at the drivers behind interest rate movements and conveyed our thoughts about where they might go in the future. Over 2022 and 2023, interest rates increased very significantly. Since March 2022, the Federal Reserve (“the Fed”) has increased the Federal Funds Rate 11 times from 0.00%-0.25% to 5.25-5.50%, a 525 basis point increase. The Fed did this in response to inflation being significantly higher than its 2% target. While this short-term interest rate skyrocketed, long term rates also increased significantly from less than 2% in March 2022 to a peak of almost 5% by October 2023. This interest rate volatility has had serious effects on everything from the real estate market, to corporate M&A activity, and to the funding levels of pension plans.
This article explores how the current economic environment affects interest rates and what may cause high interest rate volatility to continue in 2024.
Market Recap
The US Treasury yield curve has been inverted (i.e., short-term rates are higher than long term rates) since late 2022. The yield curve was upward sloping before the Fed started raising rates in 2022, as shown in the chart below. Inversions like this occur when the Fed raises short-term rates and market participants believe that they will not keep short term rates at current levels – that they will cut them reasonably soon. The Fed acted quickly to increase short term rates as inflation stemming from pandemic-related supply chain issues, fiscal stimulus, and then Russia’s invasion of Ukraine pushed inflation to levels not seen in the US since the 1980s (peaking at over 9% annualized in late 2022).
Inflation has moderated significantly with the latest readings suggesting that current inflation rates are closing on the Fed’s 2% target. Longer-term inflation expectations, as shown by 5-year / 5-year forward inflation, suggest that inflation will remain near target, though above inflation expectations pre-pandemic.
Short-Term Interest Rates:
The main driver of short-term interest rates comes from the Federal Open Market Committee’s (“FOMC”) setting of the Fed Funds Rate. The Fed’s mandate from Congress is to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” Stated differently, the Fed has a dual mandate of achieving full employment while controlling the level of inflation. The Fed’s main tool for accomplishing its objectives is through controlling the level of the Fed Funds Rate. The Fed will also regulate the amount of money supplied in the economy by buying and selling US Treasury Bonds.
The Fed took swift action in March 2020 to reduce the Fed Funds Rate to a range of 0.00% – 0.25% to try and stimulate a rapidly slowing economy due to the pandemic. It stayed at those levels until March 2022. Inflation started to accelerate in Q2 2021, and by March 2022 inflation was at 8.5%. Since March 2022 the Fed has raised the Fed Funds rate a total of 525 basis points to a range 5.25% – 5.50%.
Inflation has come down to 3.4% in December 2023 (trailing, annualized), which is slightly higher than the reading in mid-2023 when year-over-year inflation bottomed out at just below 3.0%. As inflation begins to stabilize the big question is when the Fed may start cutting rates. The current Fed consensus estimates of the year-end Fed Funds rate shows several rate cuts before the end of 2024. Whether the Fed cuts rates or not will be contingent on the strength of the labor market and any persistence in inflation readings during the year. The Fed will continue to try to balance taming inflation without slowing the economy to the point of triggering a recession.
The unemployment rate has come back down to pre-pandemic levels after reaching almost 15% at the height of the pandemic. Since employment remains strong the Fed is less likely to cut rates significantly in the short-term, especially if inflation remains above 2%. However, there is consensus that the current Fed Funds rate is above the Neutral rate (i.e. the theoretical rate that keeps employment and inflation in a state of equilibrium) and that this warrants rate cuts in 2024 to keep the economy from heading into a recession.
Long Term Interest Rates:
Long term rates are the yields available on bonds with more than 10 years left to maturity. Although the short-term rates that the Fed can control directly are important for the economy and tend to get more publicity, it is these longer rates that are more directly relevant to pension plans and other institutional investors who also invest in longer maturity bonds or which have long-maturity liabilities.
During September and October 2023, long term rates jumped with 10-year Treasury bond yields increasing over 0.75% (75 basis points) and the 30-year Treasury bond yields increasing over 0.85% (85 basis points) before falling back by year-end. This volatility was largely caused by the market re-assessing when the Fed might start cutting interest rates and how many cuts we might see. Markets had expected rate cuts to start as quickly as late 2023, in part because many investors expected the US economy to tip into a recession. When economic growth came in stronger than expected in Q3 2023, coupled with the Fed making statements to the effect of “rates will stay higher for longer” the bond market reacted violently as investors pushed off dates of the first cuts into 2024.
Long term rates tend to fluctuate as a function of three main forces: economic conditions, inflation expectations, and expectations for the Fed Funds Rate.
Economic Conditions:
Historically, the 10-year Treasury has been correlated with nominal GDP (nominal GDP is real GDP, which is what is generally what is reported as “GDP” in the media, plus inflation). While these don’t always move in lockstep, they do tend to trend in the same direction. For example, nominal GDP grew over 7.0% in 2022, and the 10-Year Treasury rate increased from 1.4% to 3.9% over that same period. Nominal GDP slowed in the first half of 2023, but then picked up strongly in the second half and long-term bond yields followed the same pattern. Based on economic expectations, we anticipate the 10-year Treasury rate to move in a downward sloping channel during 2024 from a range of 3.5% – 4.5% (it is currently about 4.15% as of this writing). It is more likely for this range to move lower than higher in 2025 as the Fed moves towards a neutral short term rate posture.
Inflation Expectations:
Annual inflation peaked at 9% in June 2022, the highest 12-month increase in consumer prices in 40 years, driven by severe supply chain pressures from the pandemic, the Russia-Ukraine conflict, fiscal stimulus, and pent-up consumer demand. Recent inflation data has shown a retreat from this high in 2023, more closely reflecting the relationship between expected inflation and long-term rates.
Current expectations of long-term inflation (which can be calculated by subtracting the yield of Treasury Inflation Protected Securities from the yield of normal Treasuries of the same maturity) implies a long-term inflation level around 2.3%. Estimates of breakeven inflation amounts have hovered between 2.0%-2.5% over the last 18 months (Source: Federal Reserve Economic Data, 10-year Breakeven Inflation Rate).
Expectations for the Fed Funds Rate:
The prevailing sentiment so far in 2024 is that the Fed won’t be raising rates again any time soon and, if anything, will lower them. Between market sentiment and the Fed’s own estimates, there is an expectation that the Fed will cut the Fed Funds Rate anywhere from 0.75% (75 basis points) to 1.5% (150 basis points) before the end of 2024.
The lower end of this range reflects ongoing market concerns about a recession. If we don’t enter a recession in 2024, then it is more likely that the Fed cuts more slowly, perhaps as little as 0.75%.
The ultimate pace of rate cuts will be largely dependent on general economic conditions and any persistency in month-over-month inflation over desired levels.
Credit Spreads:
Credit spreads are largely driven by equity market volatility and expectations of corporate defaults. Throughout 2020 and into 2021, credit spreads remained relatively elevated compared to pre-pandemic levels due to ongoing economic uncertainties. The pace of economic recovery and fiscal policy decisions played significant roles in shaping credit spread movements. As economic conditions improved, credit spreads gradually tightened, reflecting increased investor confidence and a reduced perception of credit risk. In 2023, investment grade and high yield spreads narrowed considerably as fears of an imminent recession faded. Economic activity will ultimately determine the direction of credit spreads. Spreads currently aren’t showing much fear of an imminent recession, but they could widen if economic conditions deteriorate over the year.
Pulling it all together:
Given all of the drivers of interest rates, where do we see rates going from here – especially the yields on long-term corporate bonds used to set pension liability discount rates
What we are likely to see from the Fed:
With the labor market continuing to show resiliency and inflation still running slightly higher than the Fed’s target, we expect that the Fed will cut rates more slowly than the market is currently pricing in.
What we are likely to see for longer term interest rates:
We believe that longer term rates are more likely to trend down as investors become convinced that the Fed will indeed cut rates and that inflation is unlikely to significantly re-accelerate.
What will likely happen with credit spreads:
If the economy continues to stay strong, it’s likely we will see credit spreads stay narrow or move to slightly lower levels. If signs of a weakening labor market or higher than expected inflation show, that could cause markets to start pricing in higher potential corporate default rates which would push credit spreads up.
For now, based on our outlook we think spreads will continue to be tight with the expectation of a soft-landing (i.e. no recession), inflation staying in check, and a continued strong labor market.
What could change the outlook?
The current outlook will continue to be affected by how the global economy deals with the current geopolitical climate. The potential for escalating global tensions in the Middle East, China, and Russia can have a direct effect on commodity prices and create supply chain challenges, as we are seeing currently with shipping being re-routed away from the Red Sea. These external forces could cause US inflation to remain higher than the Fed would like, slowing the pace of rate cuts and keeping longer term rates higher. Additionally, fiscal stimulus could trigger a reacceleration of inflationary pressure causing the Fed to stop or reverse course on their plans to lower the Federal Funds Rate. Conversely, the US could indeed enter a recession, prompting faster and deeper rates cuts than are currently priced in. A recession would likely lead to lower long term bond yields, even with spreads likely widening. The US election cycle could also introduce volatility if market participants believe that the path of the economy or Fed policy will be very different depending on who wins the elections.
Conclusion:
There are always unknowns when it comes to interest rate movements. Based on the current economic environment, long term rates are likely to gradually fall in 2024. For investors, especially those with interest rate-sensitive liabilities like corporate pension plan sponsors, revisiting asset allocation strategies in these environments is imperative. This is particularly true when it comes to protecting themselves from the increases in liabilities associated with declining rates. Investors should take a holistic look at their expected return, risk profiles, and liquidity needs and decide how they want to best position themselves for what is likely to come.
