In 2016, the 10 year Treasury touched lows during the summer of around 1.5% but finished the year up over 2.4%. The Federal Reserve had ended their extraordinary measures and were finally raising the Fed Funds rate. The global economy was showing signs of life and inflation was firming. As we rolled into 2017, investors braced for even higher rates. Yet halfway through 2017, interest rates on the 10 year have fallen back to 2.2%. What happened to the inevitable rise of interest rates?
There are several factors holding back rates currently. Inflation has gone soft again as the prices of many commodities are negative year over year. The most widely discussed commodity continues to be oil which shows no signs of breaking back above $60/barrel in the short term. Technology is partly to blame for holding back inflation, we have simply become better at producing goods cheaper. The shale gas development continues to grow in efficiency and challenge OPEC even at these lower prices. This is true in other industries as well.
Yields also continue to remain incredibly low across the globe which creates a drag on US rates. Germany’s 10 year remains close to 0.3% and France at 0.7%. Even Spain which still has much of a debt overhang has rates at 1.6%, lower than the US. Investor demand will remain high for US debt as long as the alternatives remain so unattractive.
The last and most important factor is growth. So far growth remains positive but has not accelerated quite as hoped in 2017. Job growth has been strong and unemployment has hit new lows but the overall economy has only been modest. Retail has been weak so far, industrial production muted, and manufacturing remains small enough not to make much of a major impact. While the news is not negative, it has not been positive enough to cause a shift in rates this year.
As we look at the back half of 2017, the path for rates to rise remains in place but at perhaps a more muted pace than the markets initially expected. Hopefully, there will be some wage pressure as the supply of workers runs out in the US resulting in both inflation and increased consumer demand. However, 2017 has further illustrated what feels like a structural change in interest rates, commonly referred to as the “New Normal.” Interest rates have stayed stubbornly low in the recovery and even as they rise, most likely will remain far lower than historical averages.