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Rising interest rates and fixed-income opportunities aren’t a given in 2015.
Everyone is sure the Federal Reserve will raise interest rates this year. Then again, everyone was sure the Fed would raise interest rates in 2014. It didn’t happen.
To be sure, the Fed could move to raise the federal funds rate. The federal funds rate is currently near zero, as it has been for the past five years. The fed fund rate matters because it is a base rate that governs commercial and consumer lending.
But as we’ve seen in these early days of 2015, interest rates continue to fall. This is despite the amplified chatter that the Fed will surely lift the fed funds rate this year. As I write, the yield on the 10-year U.S. Treasury note is 1.92%. Over the past month the yield has dropped more than 30 basis points.
The problem for the Fed is there are forces at work to keep interest rates low.
Though the U.S. economy has produced new jobs at a monthly rate of 200,000+ through 2014, the economy still wobbles from the 2008-2009 recession. The Fed frequently mentions “pockets of weakness” in its meeting minutes. Fed Chair Janet Yellen remains cautious, highlighting the need for the Fed to remain “accommodating.”
Consumer-price inflation is the primary reason I don’t expect rates to rise in the near future. Falling oil prices in the fourth quarter of 2014 ensure inflation risk remains muted. Consumer-price inflation remains below 2% in the United States, and will likely remain below 2% through the first half of 2015.
Meanwhile in Europe, deflation, not inflation, is the great concern.
The European Central Bank (ECB) recently admitted that inflation numbers will spend a large part of 2015 in negative territory. Eurozone inflation, 2% at the beginning of 2013, has steadily drifted lower since. Consumer-price inflation has been below 1% for all of 2014.
A dip into deflation is all but guaranteed for the European Union. Spain’s inflation numbers reveal the impact of tumbling oil prices. Consumer prices dropped 1.1% over the past 12 months, the fastest drop in five years, and far faster than analysts expected.
Today, you can find European bonds that actually pay a negative rate of interest. The two-year German bond is quoted at a negative 0.11%. The five-year German bond price rose to drive the yield down to a negative 0.01%. Similar negative rates are found in Switzerland. European investors are actually paying to have their money warehoused.
If the choice is between a negative interest rate, like in Germany, or a nominally positive rate, like in the United States, more investors will choose the latter. (Currency exchange risk is a mitigating factor, but the dollar remains strong.) Thus, more foreign money will flow into U.S. bonds.
More money flowing into U.S. bonds will keep U.S. bond prices high and yields low. What’s more, yields will remain low because of growth concerns in the States and the aforementioned deflation risk in Europe.
Stocks, therefore, remain attractive relative to bonds. Yields on quality dividend growers are 3% or more. The income from stocks – quality dividend stocks in particular – will remain in demand through at least the first half of 2015.
So don’t be deterred by the volatility that has rattled the stock market this year. Investors still need stocks to meet their income needs.
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