Investors continue to focus on interest rates, with good reason. Rates affect the cost and thus the willingness of consumers to buy on credit and of businesses to invest. They affect the income of creditors. They are the pricing mechanism for bonds and they influence stock valuations. Since the beginning of May, the yield of the 10-year U.S. Treasury note has climbed from 1.6% to a peak of more than 2.2% before dropping to the current 2.1%. The rise reversed a decline from 2.1% to 1.6% that occurred between early March and the beginning of May. In general terms, developed stock markets rose when yields fell. When rates rose recently, the U.S. stock market rose slightly. In contrast, developed international markets gave back their gains. Emerging stock markets have stood out, dropping 1% when interest rates declined and falling 10% amid the rate rise. Bond prices also have suffered.
Fed watch: More talk, no new action likely in the near term
We've seen interest rates gyrate like this in the recent past. The yield of the 10-year U.S. Treasury approached 2.4% in October 2011 and March 2012. The sentiment today is different largely because many investors consider the Fed's intentions to be unclear. We can't speak for others, but we are confident that the Fed will remain accommodative for the near term. The Fed has two mandates; it pursues a stable and low rate of inflation—its target is 2%—and low unemployment. The central bank's policymakers have indicated a 6.5% unemployment rate would be a threshold for a policy shift. Today, the U.S. Labor Department said the Producer Price Index, a measure of wholesale prices, was 1.7% higher last month than it had been a year earlier. The Consumer Price Index (CPI) has not been updated for May yet, but it was up just 1.1% on a year-over-year basis in April, and it has been declining. The core CPI, which excludes the volatile food and energy sectors, was up 1.7% and has been decreasing as well. The unemployment rate, which peaked at 10.0% in October 2009, stood at 7.6% last month, up from 7.5% in April. The major point is that there is no obvious reason for the Fed to alter its course soon. There is reason for policymakers to talk well in advance about ending both their purchases of bonds ("quantitative easing") and their targeting of near 0% short-term interest rates. Signaling their intentions may mean less disruption than an abrupt change when the time for change arrives.
Investor sentiment has shifted as the U.S. economy has shown more reliable results. The housing and auto industries have been doing well. Salary and wages have been increasing modestly. This is creating confidence in the economic recovery. The rise in rates reflects what we think are premature concerns about changes in Fed policy. On Friday, the International Monetary Fund cut its forecast for U.S. growth in 2014 to 2.7% from 3.0%. A lower growth forecast gives the Fed more breathing room to maintain low interest rates.
The central bank is buying about $85 billion of bonds a month. At some point it will buy less, but we would not define that as tightening, but as a reduction in easing. We do not expect interest rates to spiral higher or move high and stay there. The Wall Street Journal reported that mortgage refinancing applications have plunged 36% since May 3, as mortgage rates increased from 3.59% to 4.15%. Higher interest rates will dampen the demand for credit and slow the growth of the economy. This will put downward pressure on interest rates. While we expect interest rate volatility to increase given uncertainty about the Fed, we do not expect a sustained jump in the level of rates. The eventual increase in rates will be erratic.
Higher real interest rates: A healthy sign
While interest rates have increased lately, inflation expectations have fallen. An indicator of the rate of price changes for goods and services expected over the next five years is the "break-even rate" of inflation—the difference in yields between inflation-linked 5-year Treasury notes and conventional 5-year notes. This is now at 1.8%, which is lower than its value at the start of the year and below the Fed's 2% inflation target. A higher interest rate combined with a lower inflation rate means that the real (inflation-adjusted) rate investors receive on their bonds is higher. This is welcome news for bond buyers who have been suffering from the expected loss of purchasing power. Like blossoms in spring, increases in real yields are signs of a return to normality.
Emerging stock markets' sell-off: Fed-driven or fundamental
According to Bridgewater Associates, a Connecticut-based hedge fund operator, the emerging markets decline is related to the sensitivity of those markets to Fed tightening. Their argument is that emerging markets were propelled by the Fed's stimulative monetary policies. Concerns about Fed tightening coincide with the weakest conditions in emerging economies since the financial crisis and are driving down the stock prices. Until now we have seen emerging markets as relatively cheap for their expected rates of growth. The IMF recently forecast emerging market economic growth of 5–6% annually between 2013 and 2018. This is 3–4% faster than the rates of growth expected for developed countries. The price / earnings ratio and dividend yield on the iShares MSCI Emerging Markets ETF are 12.2x and 2.8%, respectively, according to Bloomberg. These are more attractive than the 17.9x and 2.1% values for the iShares Core S&P 500 ETF. Of course, cheap markets can get even cheaper. And emerging markets tend to be more volatile than U.S. shares. At this point we are considering whether the emerging markets' sell-off is an overreaction to premature fears of changes in Fed policy or whether we must drastically cut our growth forecasts in the area.
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