What’s going on with the interest rates?
The leading economic headline of 2021 has been the resurgence of inflation, something we haven’t seen earnest since the early 1980’s. Inflation readings began to accelerate in April. Higher inflation expectations would seemingly translate to higher interest rate expectations as investors demand higher yields to compensate for inflation as well as anticipate future interest rate increases. Yet since April, we’ve seen rates decline by over a half a percentage point, from 1.74% in March, to a low of 1.17% set a few weeks ago. As of Friday’s close, the 10-year Treasury stood at 1.31%, a rate that remains stubbornly low.
As these results have defied expectations, we wanted to highlight what we see as factors influencing the current rate environment. First, the Federal Reserve remains active in purchasing Treasuries. Every month the Fed’s quantitative easing program buys an additional $80 billion worth of Treasury bonds. This is above and beyond the amount of Treasury bonds they are buying to replace bonds maturing on their balance sheet. The Fed’s growing balance of Treasuries is resulting in their commanding a greater share of the Treasury bond market. What has made matters worse of late is that the U.S. Treasury has been issuing fewer bonds. More Treasury bonds were sold than needed last year and the Treasury has been spending down its cash balance and issuing fewer new bonds. Thus, the combination of continued demand from the Fed and lighter supply of Treasury issuance has created a unique supply/demand imbalance in the Treasury market.
There are additional demand drivers that have heightened the downward pressure on rates over the last several months. First, foreign investors have seen higher rates in the U.S. as an attractive investment proposition as many developed economies continue to have negative yields. As U.S. rates rose early in the year, and the cost of hedging foreign currencies versus the U.S. dollar has eased, this has led to a spike in foreign investment in U.S. Treasuries. Adding more fuel to the fire has been a higher level of deposits sitting on bank balance sheets. With loan demand still below pre-COVID levels, banks have been choosing to deploy these deposits into bonds, with Treasuries being a significant source of bank bond purchases. The combination of higher foreign investment and increased bond buying among banks has added additional fuel to the supply/demand imbalance within the Treasury market.
These factors have collectively contributed to what we deem to be technical factors that have influenced interest rates. Fixed income investors should recognize that the level of interest rates may be artificially low as a result of these factors. At some point, we’d expect rates to normalize. Federal Reserve Chairman Powell’s presentation on Friday at the Fed’s annual Jackson Hole summit indicated it was likely that the Fed would begin to taper, or slow the pace of its bond purchases, later this year. This didn’t seem to impact the market, as rates fell slightly following his comments. As the taper sets in, and as investors look out to a potential interest rate increase as early as late 2022, these fundamental factors could shift behavior and potentially lead to change in interest rates. However, predicting interest rates is not something we believe can be done with consistent accuracy and recognize the supply/demand imbalance could continue to persist for a while longer.
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