As I discussed in a previous Blog post, interest rates defied expectations by continuing to decline in 2014. As we enter 2015, many investors are asking the same question: Will 2015 finally be the year for rising rates?

At the beginning of each new year, investor hope seems to spring eternal: This will be the year that the U.S. recovery really takes off, inflation will remain at a healthy low level, and interest rates will rise to provide better income opportunities. And here we are again in 2015, these same themes seem to populate many annual outlooks. In previous posts, I outlined three major drivers that have kept interest rates low. Letā€™s take a fresh look at those forces to see how they might impact 2015:

  • U.S. growth and inflation ā€“ Both growth and inflation should continue to be moderate. In December a very large (+5.0% YOY) change in third quarter GDP was a positive surprise for the market. However, we expect that 2015 growth will likely come in at a more modest 2.5-3%. Inflationary pressures have declined as the price of oil has fallen below $50 a barrel, and most inflation measures are around or below 2%. Overall moderate growth and modest inflation is likely to continue in 2015.
  • U.S. Treasuries as a hedge against macro events ā€“ Recent headlines about Greece potentially leaving the Eurozone, combined with concerns over global growth and deflation, have sparked investorsā€™ concerns about macro-economic risks. My sense is that investors will continue to use Treasuries to hedge risky parts of their portfolio, and that the near term demand for Treasuries should remain strong. A lessening of this demand could push 10- and 30-year Treasury rates higher later in the year.
  • Price insensitive bond buyers ā€“ The Fed officially ended its quantitative easing (QE) program in October 2014, which removes a large buyer from the market. Central banks globally, such as the Bank of Japan and European Central Bank, will be conducting their own versions of QE in 2015. While they wonā€™t be buying U.S. bonds, the purchase of their own bonds will drive down rates in their local markets. Higher U.S. yields relative to these other markets should contribute to continued foreign demand for U.S. bonds as global investors seek out higher U.S. yields. Thus quantitative easing, this time by foreign central banks, will continue to exert downward pressure on U.S interest rates.

Given the above, I would expect longer interest rates to rise modestly over the course of the year. This should be driven by a lessening of concern over the European Union, along with a pickup in U.S. growth and inflation.

The picture for shorter term interest rates is much different. These short term rates, such as the two-year Treasury, are highly influenced by the Federal Funds rate. As the Fed begins to increase their short term target rate, we expect that two-year rates will begin to rise. Current projections have the Fed beginning hikes around September. Short term rates are likely to rise as we approach this date, and continue to rise for the rest of the year.

The net impact I expect is to have stable to rising longer term interest rates, and rising short term interest rates. Bond investors refer to this as a ā€œflatteningā€; the slope of the yield curve is getting flatter as the short end rises more than the long end. This turns out to be a very common occurrence during Fed tightening cycles. Here we can see what happened with the steepness of the yield curve and the Fed Funds rate during the last rate hikes in 2004-2006:

yieldcurve

We saw the beginning of this flattening in 2014 as the yield difference between two- and 10 year Treasury rates decreased by 1.14%, from 2.64% to 1.50%. As the yield curve flattens, I would expect this spread to continue to narrow.

So, will 2015 finally be the year for higher interest rates? Kind of. Short term interest rates are likely to rise, driven by the Fed. Longer term rates will likely move up, but not a significant amount. The key for investors is that they will need to be more precise when talking about interest rates. Saying ā€œrates will riseā€ is no longer sufficient; it is important to be specific about the interest rate. Overall for 2015, an investorā€™s location on the curve will be what matters.

 

Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor toĀ The Blog. You can find more of his postsĀ here.

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This material represents an assessment of the market environment as of the date indicated and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any security in particular.

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