US interest rates fell again today, just as they have for most of 2014. After starting the year at 3%, the 10 year yield is now 2.4%. Falling long term interest rates has been the single most important financial story of 2014. The interest rate lens explains most of the market movements that we’ve seen so far this year.
It’s been a strange environment for rates to be falling though. The US economy appears to have been improving, inflation appears to be more stable (even according to the Fed), growth expectations have mostly risen throughout the year, and the Fed has been tapering. These have been thematic elements of 2014, and all of these themes would usually suggest higher interest rates, yet interest rates have fallen.
My hypothesis as to why rates have been falling while growth expectations have been rising is that investors are comparing US interest rates to other developed countries. US interest rates are much higher than many other countries including Germany, France, Canada and, of course, Japan. However, while foreign countries’ interest rates are lower than ours, the spread is probably justified because their growth is lower than ours too.
Below is a chart of interest rates vs. nominal GDP growth of 30 different countries. It shows that interest rates track nominal GDP growth fairly well. This isn’t too surprising because nominal GDP captures both inflation and growth, which are two main inputs to interest rates. Historically nominal GDP has been closely correlated to US interest rates.
The US and UK have much higher interest rates than Germany and France, but we also have higher growth. In 2013, nominal GDP grew by 3.7% in the US and 3.5% in the UK compared to 0.88% in Germany and 1.17% in France.
Importantly, our 10 yr interest rate seems justified by the growth-defined trend-line. If anything, our rates could be a little higher based on our nominal growth rate. On average the 10 year yield of these 30 countries is 36 basis points less than the trailing growth rate of nominal GDP. That implies that US interest rates should be 3.3% based on last year’s growth. US nominal GDP has grown 4% over the last 12 months, meaning that rates could be justifiably above 3.5%.
Just like with earnings, trailing growth is not as important as future growth though, so it’s possible that rates are falling because investors are expecting lower growth and lower inflation down the road. However, if growth and inflation are slowing, then S&P earnings estimates are almost certainly too high. Interest rates and earnings estimates are painting a contradictory view of the world that will need to be reconciled.
Source: Factset Data
Photo courtesy of: cgc76
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