One of the perennial questions in the investment world over the past couple of years has been “When are interest rates going to take off?” Very soon now has been the consensus—but it hasn’t happened yet. I’ve been as guilty as anyone, although I’ve tended to say something like, “Well, about 12–18 months from now.” I’ve been saying that for the last three or four years.
Mind you, it is likely that at some point everyone will be right, and interest rates will head up. I started calling the real estate market overpriced in 2005, for example, and I was wrong for several years—until I was right. I wasn’t the only one, of course, but you can be wrong for a while before you’re eventually right. Being early, especially too early, is wrong, though.
That said, it’s worth taking a look at the fixed income markets to see what they suggest about the direction of interest rates in the near to medium-term future. The key word in that sentence is markets. As in any market, prices—which is to say, interest rates—are set at the intersection of supply and demand. To determine where interest rates are headed, it makes sense to consider what supply and demand are doing.
Let’s look at supply first. With the federal government continuing to run deficits, and corporate issuance up, the perception is that the supply of bonds is exploding. In fact, that’s not the case. According to Ned Davis Research, the total U.S. debt market increased by only 2.9 percent in 2012, the second slowest year on record. Almost all of that came from an increase in Treasury debt of around 10 percent. Corporates also increased, but by about typical levels. Mortgage-backed bonds actually decreased for the third straight year. Other sectors decreased as well.
While Treasuries and corporates can be expected to continue to increase, they should do so at a declining rate, with 2013 issuance of Treasuries down by $250 billion from 2012 levels. I think the growth rate in Treasuries will continue to decline as the deficit continues to decrease, while the growth rate in corporates will decline as companies complete refinancing of existing debt.
Overall, the supply for new debt should be relatively stable. On a supply and demand basis, unless there is a collapse in demand, a stable supply shouldn’t result in a significant change in pricing.
The demand side is also surprisingly strong. As everyone knows by now, the Fed will continue to buy securities going forward, but there is also strong demand from other official entities, especially foreign ones. While private foreign investors were net sellers, foreign official institutions bought about two-and-one-half times as much, or more than 50 percent, of net foreign purchases. Foreign interest continues to increase, even as the Fed continues its purchases. Demand remains strong.
What could go wrong? The Fed could stop buying—unlikely in the near term, and almost certain to be well telegraphed in the medium to long term. Foreigners could stop buying—possible, but given the ratcheting up of European risk, the trade imbalances, and other systemic factors, again not likely in the near term. The supply could spike if any large holder decided to dump its holdings—unlikely, as such a move would devalue the holdings even as they sold.
Overall, barring some kind of outlier event, I think interest rates appear unlikely to change radically for a while. I won’t say 12–18 months, having been bitten by that before. But given the current limited supply and strong demand, I think we need to see some changes in one of those factors before we look at changes in interest rates.