ETF Trends
ETF Trends

One investment call that most investors, myself included, got wrong last year was predicting interest rates would go up. This time around, while U.S. long-term yields have rebounded from their January lows, rates have generally been lower than where they ended 2014, calling into question: Will long rates stay low and defy expectations again in 2015? I think that is unlikely. I expect the 10-year U.S. Treasury yield higher a year from now.

Before we talk about why I think interest rates would rise, it helps to revisit some of the reasons behind the 10-year U.S. Treasury note being stuck at yielding a low 2%.

Lackluster global growth. Many economies have been struggling with well below average growth and inflation. While this phenomenon is most common among developed economies, some emerging markets also suffered from it: for example, China’s headline inflation rate recently dipped below 1%. Slow growth has led to ultra-low and often negative yields in much of the developed world, making U.S. fixed income more attractive in relative terms, even as the U.S. economy strengthens. With yield an ever-scarcer commodity, relatively high rates that U.S. bonds offer alongside a strong U.S. dollar are attracting global capital flows and pushing bond prices higher and yields lower.

Low supply, high demand. Put simply, there are not enough bonds to go around. Consumers have reined in their borrowing and governments have tried to moderate spending, which means fewer bonds have been issued. Despite the much talked about “Great Rotation” into stocks, institutional and retail investors continued to have strong appetite for bonds. Also, with central banks outside the United States undertaking large scale buying of bonds through quantitative easing, demand for bonds will probably stay high for some time.

No price growth. Although the U.S. economy accelerated last year and job creation surged, wage growth remains muted and commodity prices are plunging. This means that even in the U.S. expectations for future inflation are unusually low.

Given these market dynamics, why expect higher interest rates? Because some of these conditions are starting to change.

A nascent rise in inflationary expectations. From my vantage point, oil is likely to stabilize and inflation could return to more normal levels in the back half of 2015, pushing inflation expectations to come up from today’s very low levels. There are signals that this is already happening. Inflation expectations embedded in the 10-year Treasury Inflation-Protected Securities (TIPS) have rebounded from 1.50% in January to 1.70% today. If expectations move back toward 2%, closer to the Federal Reserve’s (Fed’s) target, this will translate into upward pressure on long-term rates.

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