Is It Time to Start Worrying About Higher Interest Rates?

At the end of 2016, the 10-year Treasury yield stood at 2.45%, the highest year-end level since 3.04% in 2013. At that time, the expectation was that yields would continue a steady upward climb due to inflationary pressures from the incoming Republican administration. While that proved to be the case the first 2.5 months of the year, the 10-year Treasury yield peaked in mid-March at 2.60% and then trended lower to 2.05% in early September before rising again and finishing 2017 much where it started at 2.40%.

In the early part of 2018, the yield furthered its upward climb, rising 54 basis points over the first five weeks. Will the large increase to start the year fade as was the case in 2017? Or is now the beginning of the long-awaited secular increase in interest rates? Unfortunately, we do not possess the credentials to confidently opine on the direction of interest rates. So, to assess the possible outcome, we quantify the implied expectations of fixed income investments covering trillions of dollars.

We start with the short-term Fed funds rate controlled by the Federal Open Market Committee (FOMC) of the Federal Reserve, which is typically the focus of media headlines for the outlook of interest rates. The new Chairman of the FOMC, Jerome Powell, offered positive overall commentary in recent Senate testimony, noting a strong labor market, an uptick in inflation, accelerating global growth and fiscal stimulus. Based on the trading of Fed funds futures contracts, the market now anticipates an approximate 85 basis point increase by the end of the year, which essentially means that the baseline is for 3-4 increases of 25 basis points each.

Using the same methodology, we determine that the 10-year Treasury yield is projected to end the year at almost 3.0%, not materially higher than the current level but implying that recent increases are unlikely to reverse.

In 4Q17 and thus far in 1Q18, the typical 30-year fixed mortgage rate averaged roughly 150-155 basis points higher than the 10-year Treasury, which is tighter than 170 basis points over the prior four quarters as increased competition among mortgage underwriters has offset a portion of the interest rate pressure. Given that we expect this competition to persist, we believe a 10-year Treasury yield of 3.0% would translate to a 30-year fixed mortgage rate of approximately 4.5%.

Even though sophisticated fixed income investors fully anticipate the FOMC to continue raising its short-term interest rate benchmark, long-term yields as framed by the 10-year Treasury and mortgage rates are expected to remain relatively low. By 4Q19, the market implies a Fed funds rate of 2.45%, a 10-year Treasury yield of 3.05% and a 30-year fixed mortgage rate of 4.60%. Said another way, the spread between the Fed funds and mortgage rates is anticipated to compress to 215 basis points by 4Q19 from 350 basis points in 1Q17. The bond market might not be right, but in our opinion, this is the cleanest assessment of market expectations to serve as a safe baseline outlook, which at this point does not appear overly worrisome for housing demand.