Market Perspectives – July 2014

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Overview: This month, we take a closer look at the interest rate environment and some of the possible reasons why rates have confounded market pundits by remaining at historically low levels. We can point to a number of factors including Federal Reserve policy, a slow-growing economy, and tame inflation data, among other things. However, many of these tailwinds, which have supported fixed income returns, are now becoming potential headwinds.

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The Interest Rate Environment

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Reason #1 – The Federal Reserve

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Tailwind The Federal Reserve has kept the benchmark rate near zero and injected unprecedented amounts of stimulus into the economy. Headwind An accommodative Fed policy is now in the process of reversing itself. The Fed continues to taper its Quantitative Easing program and could be finished with monthly bond buying later this year. The next step could be an increase in the Federal Funds Rate, which has been at 0.25% since late 2008. Markets are anticipating an increase in rates at some point during 2015.

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Reason #2 – Slower Growth Economy

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Tailwind Since 2010, the US economy has been in a ~2% GDP growth trend (and for a variety of reasons actually -2.9% in 1Q14). A slower growth environment is consistent with lower interest rates targets. Headwind Despite the 1Q14 GDP setback, which was impacted by weather, we see most recent economic data pointing to a resumption of growth. Should economic activity expand at an above-trend rate, we would expect upward pressure on interest rates from these levels.

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Reason #3 – Inflation

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Tailwind Inflation metrics have remained subdued in the US. In certain parts of the world, deflation remains a major concern. Headwind US inflation metrics have begun to tick upward and forward indicators are also pointing higher. Higher inflation could potentially force the Fed’s hand in raising interest rates in order to meet their dual mandate of price stability and full employment.

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Additional Factors Affecting Interest Rates

Low sovereign bond yields, for example in Japan, Switzerland, and certain core Eurozone countries, make US interest rates look attractive. This has led to increased interest and buying from international investors in search of yield. According to US Treasury data as of April 2014, international investors now account for a record $5.96 trillion, or roughly half of the $12.1 trillion in outstanding US government debt.

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What is the Answer?

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• Many of the tailwinds that have benefited the fixed income asset class by keeping rates so low are now becoming headwinds. The timing of a shift remains uncertain.

• The compensation which investors receive for assuming interest rate risk is low, and we believe the threat of higher rates from these levels has increased.

CONCLUSION: With interest rates appearing to offer poor risk/reward dynamics, we continue to prefer alternative investments which offer investors an opportunity for more favorable outcomes, while still helping to control portfolio volatility.

Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy.

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Disclaimer

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