Janet Yellen is considered dovish. Meaning she is more likely to maintain an easy monetary policy or on the flip side, react more slowly to improving economic conditions. This much seems well known. What we don’t know is why interest rates remain low or when they may rise. We continue to hear some, albeit few, calls for 4% rate on the 10 year Treasury note. Consensus still appears to be around 3% by end of year. Currently, the 10 year Treasury note is yielding 2.40%. For it to move up this much, strong growth needs to occur. Yellen needs to see a reason to tighten. Strong growth would include increasing employment, commodity prices, housing prices, top line revenue growth, expanding credit and so on. Remember, we need to reverse a major interest rate trend that has been in place for the past 30 years. Lower rates did not get here overnight nor did they solely result from the great recession.
What happened this spring? We saw some signs which might be best referenced as an inflation scare. We seem to see this once per year. Core CPI inflation rose by .2% or more for three months in a row, nearly creating a trend. However, the last two months have been weak. Inflation has slipped lower on a year over year basis. Wage inflation, a hot topic as of late, remains stuck at 2%, still below the long term average.
Signs of inflationary trends exist but a confirmed trend, causing CPI to increase substantially or regularly is difficult to see. Yes, in pockets, we see higher prices. Drug companies have been able to increase prices. Home prices have rebounded but the trend has slowed recently. Rents are another example. They are rising. This is followed by more construction in multifamily housing, the market filling the need.
On the flip side, the new Fed Survey of Household Economics and Decision Making (SHED) confirms many renters (59%) would like to own a home. While the data is somewhat older (Sept) the question is how high can rents move before this translates into more single family housing demand, a measure indicating stronger growth than an increase in multifamily housing. Interestingly, the survey also indicates that 45% rent because they cannot afford a down payment and 29% were unable to qualify for a mortgage. Stronger growth doesn’t seem in the cards, marginal growth may be here for the foreseeable future. Recent retail sales in rose only .1%, below expectations of .4% rise. Gasoline, the main mover of energy price inflation, has dropped more than 5%. A strong dollar also counteracts an inflationary trend. While we see economists calling for higher rates, we don’t see them calling for a weakening dollar.
Corporations have acted on low rates. Corporate bond issuance is surging and on pace for another record year according the WSJ; corporate bond sales are about to surpass the $1T mark at the fastest pace on record. Companies are using the money to retire outstanding debt at higher levels, pay for CAPEX, stock buybacks and acquisitions. Kudos to the management of these firms! More supply should push rates higher without a corresponding increase in demand. Who wants to own a bond for the next five years and receive only a 2.5% return? Of course, one cannot abandon bonds. They are an essential piece of the investment allocation mix and they do provide safety in some circumstances.
Internationally, the Eurozone economy remains frail. Easing is still the main topic and while U.S. companies stand to be beneficiary, the U.S. dollar will likely gain ground limiting inflationary pressures and at the same time, likely to help U.S. market multiples. Iron ore prices are about to break out on the downside, highlighting that China remains in a slowing trend. Japan appears to be stagnating, not rebounding. The weakness outside of the U.S. is one cause for the U.S. slow growth outlook to remain in place and supports the lower for longer view on interest rates.
The staying power for lower rates may be one of the larger factors supporting the U.S. equity market multiples. The dollar strength is another. Stable energy is helping U.S. manufacturing. While rates may rise in the future, there simply does not seem to be enough pressure at present to counter the longer term trend.
