The Economy At Large

It’s a constant struggle to separate illusion from future vision, but here are three likely paths that the evolving rate situation may take in the year ahead.

 
 

As a credit union, the evolving rate environment will no doubt play an influential role in your strategy for future business, but be wary of "certainties" culled from a crystal ball.

Back at the end of 2013 — when the 10-year note yield was 3% and the 30-year bond was 4% — it seemed at least 99% of economists were forecasting that rates would rise as the economy improved.

The economy does indeed appear to be improving and perhaps faster than most forecasters projected. But so far, a substantial rise in rates has not yet occurred, with shorter-term rates only a little changed and longer-term rates down modestly.

Because stronger economic fundamentals have not successfully moved rates (at least, not at the time of this writing), more than a few analysts have concluded that the bond market knows something and that the smart money has moved back into bonds.

I'm not sure what the definition of smart money is — my best guess is that it is whatever I'm not doing — but that's beside the point.

Although it is true that most of the time the bond market is very good at assessing current economic conditions — especially compared to the stock market — as well as the likely short-term path, the bond market itself is not blessed with some great long-term foresight. After all, if this smart money segment was so smart, why did it buy 10-year notes at a yield of 1.70% late last April and sell bonds all through last December?

Economists and analysts are grasping at straws to manufacture some sort of story to explain why rates are where they are when the real story is right in front of them. It is multifaceted but easy to understand.

  1. Rates fell in January on a combination of the weak stock market and a somewhat disappointing Christmas season. Many analysts also failed to anticipate that large money managers who run asset allocation portfolios would need to rebalance after the big stock rally in 2013 and that pension funds also needed to lock-in stock gains and better matches in long-term bonds.
  2. Rates did start to rise in February, but the flare-up in Ukraine quickly put a flight-to-quality bid in the market. That effect lingered for almost three months before just recently fading away.
  3. In March, rates again began to rise, but the NASDAQ started acting funky (Yes, that's the technical term). And rapid fire sales among once high-flying names led some analysts to conclude that something sinister was afoot.
  4. In April and May, stories of a bond shortage and a global move into bonds by "smart money" kept downward pressure on rates.

So are lower rates merely an illusion created by these one-off influences through the first four months of the year or is the bond market actually telling us something about the future? I remain convinced that it is the former.

So are lower rates merely an illusion created by these one-off influences through the first four months of the year or is the bond market actually telling us something about the future? I remain convinced that it is the former. 

At the beginning of the year I said that I thought rates would be flat to down through the first few months of the year. I also said that I expected rates to rise slowly beginning in April or May, but I remain convinced the economic data will eventually force rates higher as the aforementioned, temporary influences fade.

I also expect nonfarm payrolls to average well over 200,000 per month this year, wages to turn higher in the second half of the year, and the housing market to add to, not subtract from, the economy.

So rather than looking into a crystal ball or buying into the hype, consider the fact that there are really just three main paths along which the rate situation may actually progress:

  • Rate path #1 is the path of the "bond market knows something" and the result will be that rates will fall as the economy disappoints.
  • Rate path #2 is the path that is the current consensus on Wall Street.
  • Rate path #3 is the path that I think most likely.

Planning season is still a few months away for most of you, but it's never too early to consider both the consequences and opportunities offered by these possible scenarios.