Something Strange Happened On the Way to Higher Interest Rates This Year

Rates went down!

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The overwhelming consensus at the beginning of 2014 was for interest rates to move higher. The rate on the 10-year treasury had reached a low point during the summer of 2012. Interest rates moved higher during most of 2013, as the Federal Reserve began to end their bond-buying program known as Quantitative Easing III (QE3). The 10-year treasury finished 2013 at 3.04%. However, instead of moving higher this year, it dropped to 2.53% at the end of June.

Will rates ever return to their historic averages?

One of the most important drivers of interest rates is inflation. The Federal Reserve is constantly worried about causing inflation when using techniques to stimulate the economy. Many analysts worried QE3 would lead to inflation, as money was pumped into the financial system in an attempt to reduce unemployment. Unemployment is now nearing the Federal Reserve’s target of 6%, which is one of the reasons why QE3 is ending. Yet inflation has remained tame, with the latest consumer price index registering 2.1% inflation. Inflation has not been pushing interest rates.

Demand for credit is another factor that can move interest rates. The consumer has yet to return to their free-spending ways before the financial crisis. Americans continue to reduce their debt and pay down mortgages. Debt payments as a percentage of disposable personal income dropped below 10% in 2014 for the first time in 30 years. Corporations are using less leverage than ever*. Even the Federal government is borrowing less. The Congressional Budget Office estimates the fiscal 2014 budget deficit will be the lowest in 6 years, and down 60% from the record deficit in 2009.

None of this means that low interest rates will stick around indefinitely. A healthy economy can most likely support interest rates at levels higher than 2.53%. Rates will most likely return to their historic average of 4%, eventually. It doesn’t look like that will happen in 2014.

*Source: BEA, Standard & Poor’s, Compustat, J.P. Morgan Asset Management – Guide to the US Markets 3Q2014.

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