Low interest rates may be frustrating to investors but a godsend to homebuyers and other borrowers. But what factors have kept bond yields so low for so long, and when might yields increase? Central bank actions, demographics, and low inflation are three of many factors influencing the level and direction of bond yields, as we discuss in our recent publication on the subject in greater detail.
Although forecasting interest rates can be fraught with error, the non-partisan Congressional Budget Office prepares estimates of interest rates, including that for the 10-year Treasury note. These estimates are used for preparing the federal government’s budget, including interest expense on the federal debt. Let’s consider each of these three variables we outlined above, and then we’ll get to the CBO’s forecasts for interest rates over coming years to put these variables together in a quantified format.
Inflation has been quite low of late, with the Fed’s preferred measure of inflation, the rate tied to personal consumption expenditures (as published by the Bureau of Economic Analysis), falling consistently short of the Fed’s 2% target over the past number of years.
There seems to be a stalemate, where absent significant wage increases, workers cannot afford to pay much in higher prices. At the same time, companies have little pricing power, so they are reluctant to give their workers significant wage increases. This is especially true given low productivity gains, which are the missing ingredient that would allow profits and wages to rise at the same time. However, companies having difficulty finding workers with the skills they need amid low unemployment may potentially break this logjam.
As such, the Federal Reserve does forecast that inflation over the long run will be about 2%, and if this estimate is eventually baked into consumers’ and businesses’ expectations, there is a good chance that inflation may indeed hover around 2% in the future. After all, inflation expectations are one of the biggest drivers of the actual inflation rate.
This brings us to the next aspect of why yields are so low; namely, actions by central banks, not just the Fed but also the European Central Bank (ECB). These institutions both bought massive amounts of bonds, and in a global market, a shrinking supply of high grade bonds generally means higher prices (and lower yields).
Now, the Fed will soon begin shrinking its balance sheet, allowing maturing bonds to roll off the portfolio instead of the Fed reinvesting those proceeds in more Treasuries. Since the expansion of the Fed’s balance sheet coincided with falling interest rates; reflexively, perhaps we might suspect that the opposite action of the Fed would be consistent with a rising rate environment.
So, you may ask, what does the CBO forecast for bonds yields in coming years? The CBO believes that the 10-year Treasury yield will increase over coming years to reach 3.6% in 2023, and then the CBO assumes rates will stay around this level. Of course, when any organization publishes data such as these, it comes with the caveat that actual results will differ. And the CBO’s methodology would generally indicate a range of potential outcomes, not just the single point forecast that they publish in the federal government’s annual budget, which is the source of these forecasts.
As a result, having walked through this exercise of putting many pieces of this puzzle together, it may be logical to believe the CBO’s forecasts have merit. It’s possible that interest rates could indeed increase, should conditions in coming years dictate.
Finally, remember that any number of factors could delay, derail or speed up this trajectory. Some factors may mean a later timetable; others, an earlier one. But perhaps most importantly, our final caveat is simply to view any interest rate forecast as a wide range of potential outcomes instead of just a single number at the center, even if the thesis makes conceptual sense. That means that investors should be prepared for many possible environments – and to consider risks such as rising interest rates along with myriad other variables.
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