The Path of Future Interest Rates

The future path of interest rates is high on the list of what worries markets today. We can gain some insight by anticipating the Fed’s response to changes in the economic landscape and by looking at the pattern of yields on bonds across various maturities.

The Fed has the twin mandates of stable prices and full employment. Inflation expectations are, of course, a key consideration. After the Fed ratcheted up rates over the past two years, inflation seemed under control and a cut in the Federal Funds rate was expected. However, inflation snapped back a bit in January, putting this forecast in jeopardy, producing turmoil in markets. The Fed’s latest pronouncements are consistent with a rate cut, but further down the road once the prospects for inflation and economic activity become clearer. Thus, while the path of interest rates is for a reduction, the timing remains uncertain.

The Fed controls the short-term Fed Funds rate. Longer-term rates reflect the buying and selling by traders in the bond market, which is reflected in the pattern of yields. The observed yield is what a trader earns if the bond is held to maturity. However, there is a market in which bonds can be traded – investors do not have to hold the bond until it matures. Thus, the pattern of yields at various maturities is formed by combinations of observed and expected yields. For example, two-year yields (4.6%) include the combination of observed one-year yields (5.1%) and expected lower yields (4.2%) one year hence. Consequently, today’s pattern is telling us to expect lower rates.

While uncertainty remains, both the Fed and yields point to reduced rates ahead. We’ll see.

Market Review  

Stocks

Stock indices were up nicely in February. All but developed international markets (EAFE index), which was up 1.8%, jumped nearly 5% this month. Over the past 12 months, stock investors have been rewarded – a diversified stock portfolio earned 12%, well above historical averages. The S&P 500 12-month return of 31% stands out.

The S&P 500 continues to be driven by the results of the largest tech companies engaged in the development of Artificial Intelligence (AI). Nvidia, the premier manufacturer of chips for AI, is the poster child. Its recently reported earnings were well above market expectations producing a one-day pop of over 16% on the news. It is up 29% in February and 243% over the trailing twelve months – extraordinary results indeed.

China is about 25% of our emerging markets index and explains much of its volatility. A proxy index for China’s stock market was up 10% in February, but about flat over the last quarter and down nearly 20% over the trailing twelve months.

Bonds

Our Treasury bond indices were down from 0.3% for short-term maturities to almost 3% at the longer end in February due to rising yields. The total increase in 5-year and 10-year yields of about 0.5% is explained in equal measures by increasing inflation expectations and an uptick in the underlying cost of capital.  Over the trailing 12 months, Treasury securities maturing in the 3–5-year range earned 4.2%, a 1.4% premium above inflation (CPI).