Where are Interest Rates Headed?

By Brad Thomason, CPA
  
According to the models we use for forecasting interest rate moves, three clear possibilities have emerged.  We see them rising, falling or staying pretty much the same.
 
Sorry.  That was funnier in my head.
 
Someone told me a long time ago that trying to guess where interest rates are headed is a sucker bet.  They were probably right.  Most of the people I have met over the years who were the most certain about where rates were headed have been almost universally wrong.  It’s like the more convinced you are, the less likely the powers-that-be are to give you what you want.
 
Still, interest rates are important, a lot of people watch them, and it therefore becomes impossible not to speculate a little.  Or at least wonder.
 
A gauge that I have always found interesting is the relationship between rates for junk bonds versus other more mainstream types of debt.  The theory is that since the lower-rated bonds have a higher likelihood of default (which is why they have the lower rating…), then you have to pay a higher rate to get investors to take the risk.
 
Which is sound logic at all times; yet what “higher” means fluctuates rather widely from one year to the next.
 
At present the spread between junk bonds and Treasuries has dipped to less than four percentage points (400 basis points, if you want to get all fancy).  Compare that to a historical average of probably between 6% and 7% (depending on how far back you look).

The St Louis Fed has a nice chart, if you want to take a look.  
 
In simple terms, this means that bond buyers are willing to take a smaller amount of additional interest for their risk, than usual.  Why they might do that, perhaps, provides some clues as to what they think is on the horizon for interest rates.
 
One theory would be that they wouldn’t lock up money for a long time if they thought a rise in rates was coming any time soon.  They have to park the money somewhere, and if the current rate is as good as they are likely to get for the foreseeable future, then earning something is better than earning nothing sitting in cash.
 
Another theory is that they wouldn’t pay such a high premium, unless they could pick up a profit doing so.  What would lead to such a profit?  A drop in interest rates.  If Treasury rates drop, that spread widens, and the value of the junk bonds would go up.  In theory.  A nice trader’s play.
 
There’s no real way to know which theory drove the action that got us to this point on the spread differential.  And even if we did know why they acted, there’s no guarantee they guessed right and will get the win they are after.
 
But what’s interesting to me about both possibilities is what they aren’t: neither is a vote for the idea that rates are going higher. 
 
People who think rates are rising stay in cash to get the higher rate later, and duck the capital losses that come from being long bonds when the prices are falling (remember that rates and prices move in opposite directions in the bond market).  They don’t buy now.  And they sure don’t pay extra.
 
I hear growing talk that higher rates are coming.  Maybe they are.  But based on the spreads in the junk bond world, it doesn’t appear that those folks think so. 
 
Recall also that for interest to get high and stay high, someone has to agree to pay the actual interest.  That little consumer-centric fact is almost always left out of the discussion when investment people start talking.  But it’s not a minor point.  Individuals, businesses and the real estate community all have a lot of financing options these days, and no one seems to be eager to pay a lot more for the use of that capital.

An additional bit of commentary which may be meaningful is the trend in Treasury yields over the last few months.  Since the beginning of the year, short term Treasury yields are up.  but the the 30 year is basically right where it started the year (i.e. the yield curve has "flattened" over the course of the last 6 months).

 So, I don’t know where rates are headed.  But if you think that it is a foregone conclusion that they are headed dramatically higher, it might be worth considering why some of your fellow market participants – ones who control an awful lot of capital – apparently think otherwise.  Because somebody is going to end up being wrong.