Low interest rates depicted by percentage sign and a downward-pointing arrow
The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
Since 2008, the Federal Reserve has implemented a number of unusual monetary policy measures due to the financial crisis and its aftereffects. As a result, interest rates have declined to levels at or near historical lows; however, many investors and borrowers are now focused on the following question: What is the outlook for interest rates in 2012?
Lower interest rates
In order to think about where rates are headed in 2012, it is important to review how rates got to where they are today. In September 2007, in response to the slowing U.S. economy, the U.S. Federal Reserve (the Fed) began to lower its target for the federal funds rate, which is the interest rate it uses to conduct monetary policy. The first cut was from 5.25% to 4.75%; however, the Fed followed up with additional cuts over the next 15 months, with the last cut occurring in December 2008 and taking the target federal funds rate to the 0-0.25% range that still prevails today.
This period also saw sharp declines in longer term rates, which are set by the market rather than a government organization, such as the Fed. For example, between September 2007 and December 2008, the U.S. 3-month London Interbank Offered Rate (LIBOR), which is the reference rate upon which many floating rate loans are based, declined from about 5.7% to about 1.5%. (See Figure 1.) Additionally, the 10-year U.S. Treasury (10-yr UST) yield, which is the reference rate upon which many fixed-rate loans are based, declined from about 4.5% to 2.1% over the same period.
Extraordinary measures
In addition to aggressively lowering the target federal funds rate, the Fed has implemented a number of unusual monetary policies since 2008, which it described as "extraordinary measures." These included two rounds of bond purchases, referred to as quantitative easing, and lengthening the average maturity of treasuries held in its bond portfolio, dubbed Operation Twist after a similar program that the Fed instituted in the 1960s. As a result of these measures, the Fed's balance sheet expanded significantly, growing from about $870 billion in June 2007 to more than $2.9 trillion in February 2012. Additionally, after its regular meeting in August 2011, the Fed announced plans to keep the target federal funds rate at 0-0.25% until at least mid-2013, which was the first time the Fed ever gave a specific date rather than using the term “extended period.” After its regularly scheduled meeting in January 2012, the Fed extended this pledge to keep the target federal funds rate at 0-0.25% from mid-2013 to late-2014.
The goal of these measures was to lower longer term interest rates even further in hopes of avoiding deflation, reducing the unemployment rate and ultimately spurring a recovery in the U.S. economy. Despite these actions, longer term interest rates declined only slightly, with the 10-yr UST falling from about 2.1% at the end of 2008 to about 2.0% in February 2012; however, shorter term rates fell further, with LIBOR falling from 1.5% to 0.5% over that same period.
Interest rate outlook
Given the continuation of Operation Twist until the end of June 2012 as well as a commitment to keep the target federal funds rate at 0-0.25% through late-2014, the consensus view (i.e. median forecast) is that short-term interest rates should remain stable in 2012, while longer term rates are forecast to rise modestly. For example, the median forecast in the most recent Bloomberg survey of economists’ forecasts calls for LIBOR to remain about 0.5% through the end of 2012. (See Figure 2.) Conversely, the median forecast from this same survey calls for the 10-yr UST to rise slightly throughout 2012, finishing the year at about 2.5%.
Rather than take the consensus at face value, it also is important to consider potential risks to this forecast. Although there is currently a great deal of uncertainty throughout global markets, leading to uncertainty about the future path of rates in the United States, the following four factors could have the biggest impact on U.S. rates in 2012.
1. U.S. Economy: Despite a commitment to refrain from doing so until late-2014, the Federal Reserve could respond to significant improvement in the U.S. economy with an increase to the target fed funds rate. This is unlikely, however, as the outlook for 2012 includes slower than average gross domestic product (GDP) growth and a modest decline from a still high unemployment rate.
2. Additional Fed Actions: Given the stubbornly slow economic recovery in the U.S., the Fed could take additional measures to spur economic growth, including a third round of quantitative easing. It is unclear if this would impact LIBOR or the 10-yr UST yield because many believe a third round of quantitative easing should focus primarily, if not exclusively, on residential mortgage-backed securities (RMBS) in order to more directly benefit the U.S. housing market.
3. U.S. Credit-Rating Downgrade: After the Standard & Poor’s downgrade of the U.S. credit rating from AAA to AA+ in August 2011, some forecasters believe that a downgrade from Moody’s or Fitch could result in forced selling of U.S. Treasury securities, causing interest rates to rise. Although forced selling due to further downgrades is certainly possible given problems with the budget deficit and continued political gridlock, the United States remains one of the best sovereign credits in the world, particularly relative to the situation in Europe, and interest rates should likely rise just marginally in the event of forced selling.
4. Euro Crisis: Much of southern Europe continues to struggle with large amounts of government debt, which has led to higher government bond yields and slower economic growth. As a result, many investors are fearful of potential credit losses, causing them to sell European government bonds and buy U.S. Treasury securities due to their perceived safe haven status. Therefore, a continuation of the euro sovereign debt crisis could support demand for U.S. Treasury securities, thereby helping yields remain low throughout 2012.
Given that U.S. interest rates are near all-time lows, it is difficult to assign a high probability of them moving appreciably lower in 2012. Conversely, the current issues facing global markets, as discussed above, make it unlikely that interest rates should move significantly higher over the coming year. Although rates could experience some short-term volatility throughout 2012, moving slightly higher on good U.S. economic news or slightly lower on fresh bad news related to the euro crisis, U.S. interest rates should ultimately finish 2012 not far from where they began the year.
The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
Since 2008, the Federal Reserve has implemented a number of unusual monetary policy measures due to the financial crisis and its aftereffects. As a result, interest rates have declined to levels at or near historical lows; however, many investors and borrowers are now focused on the following question: What is the outlook for interest rates in 2012?
Lower interest rates
In order to think about where rates are headed in 2012, it is important to review how rates got to where they are today. In September 2007, in response to the slowing U.S. economy, the U.S. Federal Reserve (the Fed) began to lower its target for the federal funds rate, which is the interest rate it uses to conduct monetary policy. The first cut was from 5.25% to 4.75%; however, the Fed followed up with additional cuts over the next 15 months, with the last cut occurring in December 2008 and taking the target federal funds rate to the 0-0.25% range that still prevails today.
This period also saw sharp declines in longer term rates, which are set by the market rather than a government organization, such as the Fed. For example, between September 2007 and December 2008, the U.S. 3-month London Interbank Offered Rate (LIBOR), which is the reference rate upon which many floating rate loans are based, declined from about 5.7% to about 1.5%. (See Figure 1.) Additionally, the 10-year U.S. Treasury (10-yr UST) yield, which is the reference rate upon which many fixed-rate loans are based, declined from about 4.5% to 2.1% over the same period.
Extraordinary measures
In addition to aggressively lowering the target federal funds rate, the Fed has implemented a number of unusual monetary policies since 2008, which it described as "extraordinary measures." These included two rounds of bond purchases, referred to as quantitative easing, and lengthening the average maturity of treasuries held in its bond portfolio, dubbed Operation Twist after a similar program that the Fed instituted in the 1960s. As a result of these measures, the Fed's balance sheet expanded significantly, growing from about $870 billion in June 2007 to more than $2.9 trillion in February 2012. Additionally, after its regular meeting in August 2011, the Fed announced plans to keep the target federal funds rate at 0-0.25% until at least mid-2013, which was the first time the Fed ever gave a specific date rather than using the term “extended period.” After its regularly scheduled meeting in January 2012, the Fed extended this pledge to keep the target federal funds rate at 0-0.25% from mid-2013 to late-2014.
The goal of these measures was to lower longer term interest rates even further in hopes of avoiding deflation, reducing the unemployment rate and ultimately spurring a recovery in the U.S. economy. Despite these actions, longer term interest rates declined only slightly, with the 10-yr UST falling from about 2.1% at the end of 2008 to about 2.0% in February 2012; however, shorter term rates fell further, with LIBOR falling from 1.5% to 0.5% over that same period.
Interest rate outlook
Given the continuation of Operation Twist until the end of June 2012 as well as a commitment to keep the target federal funds rate at 0-0.25% through late-2014, the consensus view (i.e. median forecast) is that short-term interest rates should remain stable in 2012, while longer term rates are forecast to rise modestly. For example, the median forecast in the most recent Bloomberg survey of economists’ forecasts calls for LIBOR to remain about 0.5% through the end of 2012. (See Figure 2.) Conversely, the median forecast from this same survey calls for the 10-yr UST to rise slightly throughout 2012, finishing the year at about 2.5%.
Rather than take the consensus at face value, it also is important to consider potential risks to this forecast. Although there is currently a great deal of uncertainty throughout global markets, leading to uncertainty about the future path of rates in the United States, the following four factors could have the biggest impact on U.S. rates in 2012.
1. U.S. Economy: Despite a commitment to refrain from doing so until late-2014, the Federal Reserve could respond to significant improvement in the U.S. economy with an increase to the target fed funds rate. This is unlikely, however, as the outlook for 2012 includes slower than average gross domestic product (GDP) growth and a modest decline from a still high unemployment rate.
2. Additional Fed Actions: Given the stubbornly slow economic recovery in the U.S., the Fed could take additional measures to spur economic growth, including a third round of quantitative easing. It is unclear if this would impact LIBOR or the 10-yr UST yield because many believe a third round of quantitative easing should focus primarily, if not exclusively, on residential mortgage-backed securities (RMBS) in order to more directly benefit the U.S. housing market.
3. U.S. Credit-Rating Downgrade: After the Standard & Poor’s downgrade of the U.S. credit rating from AAA to AA+ in August 2011, some forecasters believe that a downgrade from Moody’s or Fitch could result in forced selling of U.S. Treasury securities, causing interest rates to rise. Although forced selling due to further downgrades is certainly possible given problems with the budget deficit and continued political gridlock, the United States remains one of the best sovereign credits in the world, particularly relative to the situation in Europe, and interest rates should likely rise just marginally in the event of forced selling.
4. Euro Crisis: Much of southern Europe continues to struggle with large amounts of government debt, which has led to higher government bond yields and slower economic growth. As a result, many investors are fearful of potential credit losses, causing them to sell European government bonds and buy U.S. Treasury securities due to their perceived safe haven status. Therefore, a continuation of the euro sovereign debt crisis could support demand for U.S. Treasury securities, thereby helping yields remain low throughout 2012.
Given that U.S. interest rates are near all-time lows, it is difficult to assign a high probability of them moving appreciably lower in 2012. Conversely, the current issues facing global markets, as discussed above, make it unlikely that interest rates should move significantly higher over the coming year. Although rates could experience some short-term volatility throughout 2012, moving slightly higher on good U.S. economic news or slightly lower on fresh bad news related to the euro crisis, U.S. interest rates should ultimately finish 2012 not far from where they began the year.
More Articles From Lancaster Pollard:
Opportunity Knocking: Taking Advantage of Low Short-term Interest Rates
The Importance of a Strong Investment Policy Statement
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