Economic uncertainty has been the order of the day since the market crisis of 2008, resulting in interest rates near zero. At the beginning of 2010, the market expected the Federal Reserve to begin its exit strategy by raising interest rates in the second quarter, but those expectations were pushed back due to instability in the financial markets and, to a certain degree, by the sovereign debt crisis in Europe.
In the minutes of its April 27-28 meeting, the Federal Open Market Committee (FOMC) said economic conditions would equal “exceptionally low levels of the Federal Funds rate for an extended period,” and most members predicted economic slack “would continue to be quite elevated for some time, with inflation remaining below rates that would be consistent in the longer run with the Federal Reserve’s dual objectives.” And inflation concerns seem to be in check, as the minutes also noted that consumer price inflation was low in recent months and survey measures of long-term inflation expectations were fairly stable.
Analysts expect the Fed to begin raising rates at the beginning of 2011 at the earliest. And based on Fed Funds futures, most traders don’t expect a rate hike until early 2011 (see “Watching the Fed”).
“The combination of the European crisis, [concerns] about China overheating, and evidence that the U.S. inflation story is not inflation but deflation, has given us an [unusual] rate structure,” says Cary Leahey, senior managing director at Decision Economics. “In the short run, as long as the EU and China are on the front pages of the financial publications, the worst-case scenario for U.S. interest rates is sideways. The Fed’s not going to hike interest rates until 2011. The structure on rates is flat to up.” Leahey predicts 3.75-4% on the 10-year yield by the end of 2010. “We’re probably now at the lows,” he says, adding that he expects interest rates to be 50-100 basis points higher than the current levels by the end of the year.
Kim Rupert, managing director for fixed income at Action Economics, also doesn’t expect a rise in interest rates until 2011 and says the market likely won’t try to push rates up on its own because the recovery is still very modest. “With inflation not appearing too threatening right now, especially if the labor market doesn’t improve much and the recovery remains very tepid, the vigilantes [won’t] have much of a case” to push rates up on their own, she says. For the end of the year, she predicts three-month Libor at 99.150, 30-year futures at 118-04, 10-year futures at 117-13, five-year futures at 115-25, and two-year futures at 108-15.
Carley Garner, trader and analyst at DeCarley Trading, says the market may attempt to push rates higher, “but [I doubt] they’ll be successful. We won’t get any dramatic changes in interest rates based on investor moves and manipulation.” She expects 10-year futures to be above 115 at the end of the year, likely most comfortable near 117, and says the 30-year bond could be trading in the 114 to 116 range by year’s end.
Mike Kimbarovsky, principal at Advocate Asset Management, expects the Fed to begin its exit strategy at the end of 2011 or in 2012, after first selling assets on the Federal balance sheet. “That will have the secondary impact of raising capital markets rates, so they don’t have to raise the official interest rates to get the capital market rates to rise,” he says. By the end of 2010, he expects the 10-year yield to be in the 3.5% range, the two-year to be at 1%, and the 30-year to be in the 4.5% range. As for the three-month Libor, he says, “I wouldn’t be surprised if it went to the mid-3s. I don’t expect major movements.”
Dave Floyd, head of FX research and trading at Aspen Trading Group, also doesn’t expect Libor to move much as long as long as Spain and Portugal don’t implode economically. “If there are no crises, Libor should be okay for the remainder of the year. I’m looking for rates to be sideways or in a trading range,” he says, adding that on the 10-year yield, “if we hold the 3% level, we’re going to be in a trading range for the rest of the year, between 3%-4%.” He doesn’t expect the market to take rates higher, saying it will want to see some indication that economic growth is on firmer footing first.
The economic crisis in Europe began with severe weakness in Greece and other PIIG nations (Portugal, Ireland, Italy), leading to a major battering of the euro and subsequent €750 billion ($1 trillion) joint European Union and International Monetary Fund bailout package for Greece in May 2010. Analysts say the situation in Europe could have an impact on recovery in the United States. However, weakness in Europe also could have a domino effect and lead to weakness in China, a major driver for worldwide economic growth.
“The repercussions around the world of weaker European growth [could] hurt Asian exports to Europe. So Europe’s downfall will mean weakness in export-driven countries, such as most of Asia. If Asia weakens, especially China, that’s going to bring down the growth rate around the world,” Rupert explains.
“The European government is in the driver’s seat when it comes to recovery,” Garner says. “If they don’t contain their debt problems there, it’ll basically freeze the credit markets.”
Leahey says that while the direct linkages of the United States and Europe through trade are relatively small, the indirect linkages to the credit markets are big. “If the money markets freeze up, that could give you a Lehman-style blowout and the economy could go back into the tubes. [Europe needs] a stronger growth picture. Germany has to be willing to grow faster. How is Portugal going to tighten its belt and avoid a deep downturn without Germany growing faster and buying its stuff? If Germany wants to grow slowly, that may end up killing the euro. Not because they’re not willing to put up the money, but because they’re not willing to put up the growth,” he says.
Kimbarovsky doesn’t think Europe’s impact on economic recovery will be quite as significant. “[The U.S.] has such an import-oriented economy that that’s going to drive [recovery] more so than what’s happening in Europe,” he says. “The big player in the next 10 years will be China. They have a lot of reserves.”
Floyd says that if the Chinese economy does slow down, it could further dampen the hopes of a recovery. “The Australian dollar has [experienced weakness] and that could be a result of China. Commodity prices have come up. Those are not signs of a robust economic recovery by any stretch,” he adds.
But for now, the economic picture in China looks bright. In its April meeting minutes, the FOMC noted that China’s real gross domestic product (GDP) increased at a higher than expected annual rate in the first quarter as economic recovery remained broad based with continued growth in industrial production, investment and domestic demand.
Back in the United States, unemployment continues to weigh on the overall economy, with the jobless rate sitting at 9.7% in the May report. The FOMC at its April meeting predicted a 9.1 to 9.5% rate for the fourth quarter of 2010, declining to 6.6 to 7.5% by the end of 2012 (see “Making it work”).
Most analysts agree that although jobs recovery is coming, it won’t be swift by any means.
“If the economy doesn’t pick up more robustly than the 2.5% to 3.5% growth rate that we’re currently expecting, then the labor market won’t have much chance either,” Rupert says. “Unemployment rates [won’t] really come down until the middle of the decade.”
Garner says the jobs outlook will improve, but not overnight. “[After layoffs during the recession], firms have found that they can conduct business with a lot less people than they thought they could.”
Leahey offers a good news-bad news scenario on the jobs market. “We’re generating a number of private sector jobs. The gains are quite impressive and broad-based. Unfortunately, in the last 20 years, we’ve had slower job recoveries and in this case we have a deep hole of eight million workers who lost their jobs. Even if you assume 150,000 job gains per month for the next five years, you wouldn’t get the level of employment back to where it was in 2007 until 2015,” he says.
Kimbarovsky provides a brighter outlook. “When you’ve reached equilibrium on net firings, you’re only looking in one direction and that’s up,” he says.
Although recovery will be slow, the economy appears to be headed in the right direction. The FOMC in its April meeting raised expectations for GDP growth in the U.S. to 3.2% to 3.7%, up from its January predictions.
In this environment of sluggish economic recovery and uncertainty, traders need to be cautious. Kimbarovsky says the current environment makes it difficult to trade based on fundamentals. “You have an overwhelming political cover for what’s essentially 40-50 years of excess. It doesn’t resolve itself in six months or a year,” he says.
Everyone knows that interest rates eventually must rise, but the recent credit crisis has been unique, so there is no easy roadmap to follow for fixed income markets as we slowly move from recession to recovery.