One potential reason that rising rate concerns surface early in the year could be tied to the eternal optimism that investors seem to feel at the beginning of each year. Economists and investors alike re-set their economic forecasts in January, and they generally have a rosy outlook. Growth will return to normal levels, employment will go up, equities will rise, and yes, bond yields will rise as well. You can see this optimism in equity returns – S&P 500 total returns averaged nearly 8% in the first quarters of 2010, 2011, and 2012. So far this year, it’s up over 8%. As investors compare their strong equity returns to their fixed income returns each Q1, they likely began to express concerns about further rate increases.
Personally I find this timing of expectations resetting to be a bit arbitrary. Markets and economic cycles don’t follow a calendar; there is no reason that the outlook should be significantly different on January 1 than it was on December 1. The 10-year UST does not celebrate New Year’s and isn’t prone to annual bouts of euphoria.
Which brings me to the second question. Despite the turning of the year, the interest rate landscape is largely unchanged. I’ve written before about the three major factors that will likely keep rates low: moderate US growth and inflation, investor demand for US Treasuries to protect against macro risks such as European debt problems, and non-price sensitive UST buyers such as the Fed and other central banks. None of these factors have changed significantly in the first few weeks of this year. This point was reinforced by the recent surprise election in Italy which prompted renewed concern over the European fiscal situation and sent the 10 year UST back down to 1.85%.
Could we see higher 10-year UST rates in December? Of course, but it will require a true shift in economic conditions, and likely a shift in policy by the Fed. Keep an eye on the words and actions of the Fed governors. Based on the most recent FOMC meeting minutes it appears that a healthy debate is emerging about the current QE purchases and their long term impacts. A change in Fed policy and rhetoric is the kind of trigger that could lead to higher interest rates, regardless of the month that it occurs.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.