Investment Insights: Interest Rates, Under Pressure
27 September 2018
By Cliff Aque, CFA, Investment Strategist
Interest rates have been on the rise this year, although it has been a bumpy ride, the 10-Year Treasury yield has climbed from 2.5% in January to about 3.1% as of this writing. There are many factors that play into the level of interest rates, such as economic growth, housing prices, unemployment, or wage growth. But the simple economic theory of supply and demand might also help explain the movement in interest rates this year.
Let’s examine supply first. If supply expands faster than demand, then prices should go down, which pushes rates up. Treasury supply was expected to be high this year due to an expanding national deficit from fiscal stimulus and tax cuts. The Congressional Budget Office said that for the first 11 months of fiscal 2018, the deficit was $895 billion ($222 billion more than the same period last year). Revenues were 1% higher, but outlays rose by about 7%1. At the end of July, the Treasury Department estimated it would need to borrow $769 billion during the second half of 2018 alone2. Below is a look at net issuance by year from 2000 through August 2018.
Source: Securities Industry and Financial Market Association (SIFMA) Note: August includes $794 billion in net issuance as reported by SIFMA plus $231 billion from the Fed’s reduction in its System Open Market Account (SOMA), which grew to over $4.5 trillion during the Fed’s Quantitative Easing program.
To be fair, issuance has been rather high since the financial crisis, but net issuance is set to hit levels not seen since 2008 and is projected by many to stay above $1 trillion for each of the next five years. According to the IMF, the United States is expected to be the only advanced economy to increase its debt-to-GDP ratio over the next five years3. To keep a lid on rates rising much further, there will have to be enough demand for these bonds.
So far this year domestic buyers have stepped up demand for Treasuries as individuals and mutual funds purchased $500 billion in Q1 alone4. According to Morningstar, investors have poured $49 billion into their Intermediate-Term bond category, $48 billion into Ultrashort Bond, and $12 billion into Long Government through August. Retail investors have added to bond funds in nine out of the last ten years, which has supported lower rates, but is this sustainable?
Source: Securities Industry and Financial Markets Association (SIFMA)
Individuals and mutual funds only make up 20% of Treasury holders, so let’s look at the other holders. The Fed holds about 15% ($2.4 trillion), but has not been a buyer since 2014 and began slowly unwinding its holdings at the start of 2018. Foreign holders own 39% of the market ($6.4 trillion), but have also not been a buyer since 2014. If rates stay low globally, then perhaps U.S. Treasuries will appear attractive relative to other countries which could spur some international demand, but we have not seen it thus far.
The supply/demand dynamics around the Treasury market are important to watch as a driver of interest rates. With trillions of Treasury supply due to hit the market in the coming years, if demand does not keep up, then rates will remain under pressure
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