OUTLOOK FOR U.S. INTEREST RATES:
AN ANALYSIS OF FUNDAMENTAL FACTORS
Weekly
Economic
Perspective
Robert F. DeLucia, CFA
May
31st,
Consulting Economist
2011
Summary and Major Conclusions:

The steady decline in Treasury yields has
surprised many investors. The surge in
commodities, escalating headline inflation,
growing U.S. fiscal and public debt
pressures, and market anticipation of the
end to FOMC purchases of government
bonds would normally exert upward
pressure on interest rates.

However,
the
current
economic
environment is far from normal: Market
interest rates tend to languish during a
post-bubble credit contraction, the result
of deflationary pressures and a severe
disruption of the credit creation process.

Decomposition of interest rates between
inflation and real yields reveals that the
decline in market rates has resulted
primarily from a collapse in real yields as
opposed
to
falling
inflationary
expectations. The current real yield on 10year TIPS has declined to 0.75%, near alltime lows.

Analysis of fundamental determinants of
interest rates suggests that market yields
are likely to remain at historically
depressed levels for the foreseeable
future. These include: Sluggish economic
growth; weak private credit demand;
historically low levels of underlying
inflation; and continued monetary ease by
the Federal Reserve.
INST #0169232-00001-00

My forecast assumes that government
bond yields will fluctuate within a narrow
range of 3% - 4% during the current year,
as measured by 10-year Treasury notes. A
slight rise in the trading range to 3.5% 4.5% appears likely during 2012.

At the same time, my forecast assumes
that the current depressed interest rate
structure is not sustainable, and that a
return to normal equilibrium levels is likely
in future years. In a steady-state
environment of a 3.5% federal funds rate,
the
equilibrium
rate
for
10-year
government bonds is estimated at 5.5%,
which is unlikely to be attained until 2013
or 2014.

An end to the Federal Reserve's
experiment with quantitative easing is
unlikely to have an immediate impact on
market interest rates, for two reasons: (1)
Withdrawal
from
large-scale
asset
purchases by the FOMC is expected to be
a gradual process; and (2) The direction
of rates will likely be predicated upon
fundamental economic factors, which
should remain supportive of lower market
yields over the next 6-12 month period.
Economic Perspective – May 31, 2011
"Since April 18, the prices of Treasuries have not
fallen. To the contrary. They've risen while yields,
which move in the opposite direction, have
plummeted. Despite a mounting debt burden and
a dithering government, Treasuries have rallied.
CORE CONSUMER PRICE DEFLATOR
U.S. GDP ACCOUNT
Annual % Change 2002-2011
Source: Bloomberg
Factor in the pronouncements of the Federal
Reserve, and the situation is even more puzzling.
In its program of quantitative easing (QE2), the
Fed has been buying longer-term Treasuries. But
it says that it will end the program on schedule
next month.
Any economics student knows that when you cut
demand - in this case when the Fed ends QE2 all things being equal, prices ought to decline.
And yet, despite the Fed's announcement, prices
have
risen
and
yields
have
fallen
to
extraordinarily low levels."
The New York Times
Sunday Business
May 29, 2011
Market interest rates have behaved in an erratic
manner over the past year. After peaking at 4%
in April of last year, the benchmark 10-year
Treasury note declined by more than 160 basis
points to 2.4% in August. Rates jumped by 135
basis points to 3.75% early this year, only to
decline to 3.08% through the end of May. Bond
yields have averaged 3.25% since the beginning
of 2010 and 3.35% over the past three years.
This compares with an average of 4.75% over
the ten-year period ending in 2008 and 8.5%
over the twenty years ending in 1999.
Real Yields and Inflation - The Treasury
market has been driven by major crosscurrents
between real yields and inflationary expectations.
An examination of the TIPS market (Treasury
Inflation-Protected Securities) indicates that the
decline in bond yields since February has been
primarily driven by declining real yields as
opposed to falling inflationary expectations.

Falling Real Yields - Specifically, real
yields in the TIPS market on bonds with a
10-year maturity have declined by 75
basis points since February, while implied
future inflation has risen by 15 basis
points. The net result has been a decline
in market yields of approximately 60 basis
points. The current real yield of 0.75% on
10-year TIPS is close to all-time lows
since the inception of the TIPS market in
1997. Real yields on 5-year TIPS are
actually negative. Depressed real yields in
the TIPS market are consistent with
investor
expectations
of
continued
economic weakness.
Investor Conundrum - It is understandable
that many investors are perplexed by the recent
behavior of market interest rates. Nearly two
years into an economic recovery, bond yields
have persisted at levels significantly below
historical averages and have failed to maintain a
sustained rise. Adding to the confusion are recent
developments that would normally be expected
to exert upward, rather than downward, pressure
on market yields:







Steady improvement in job creation
Sharp increases in headline inflation
Surging prices of crude oil, commodities,
and precious metals
Relentless declines in the U.S. dollar
Growing concerns over rating agency
downgrades of U.S. sovereign debt
Record federal budget deficits and surging
public debt outstanding
The imminent end to the Federal
Reserve's large-scale asset purchases of
Treasury securities (QE2).
Economic Perspective – May 31, 2011
U.S. COMMERCIAL BANKS
Commercial & Industrial Loans
$ Billions 2005-2011
Source: Bloomberg
While these developments are certainly relevant,
they ignore the unique underlying economic and
financial realities associated with the current
business cycle recovery. The following provides
an
analytical
framework
of
the
critical
fundamental factors that are most pertinent to
the direction of interest rates.
FIVE CRITICAL ECONOMIC VARIABLES
As I have discussed on numerous occasions in
the past, there are six key fundamental factors
that largely determine the direction of rates:
(1) Economic Growth - While the domestic
economy appears to be on a sustained growth
track, the pace of growth remains sluggish and
well below the pace of previous economic
recoveries. Moreover, the U.S. economy has
entered a soft patch - which could persist for
another 3-6 months - with GDP slowing from
trend growth of 3% to a pace of only 2%.

Potential Growth - While a return to
recession is not likely, economic growth at
below-average rates is consistent with
continued very low interest rates. A return
to an environment of sustained growth in
real GDP in excess of long-term potential
growth - estimated at 2.75% - is unlikely
until the 2012-2013 period. There is a low
probability of a material rise in interest
rates over the foreseeable future.
(2) Private Credit Demand - An important
depressant upon market yields over the past
three years has been the profound weakness in
private credit demand within both the household
and business sectors. Following many years of
annual growth of 12%, the level of household
sector debt has plummeted since 2008, the result
of widespread deleveraging of balance sheets
(see chart).

Deleveraging - Consumers are still
trimming credit card balances while the
demand for mortgage debt remains
depressed. Similarly, business credit
demand remains weak because capital
expenditures have been funded primarily
through internal cash flow. Commercial
and industrial (C&I) bank loans have
been in a declining trend for three years,
and have only recently begun to stabilize
(see chart) at levels well below prerecession peaks. A sustained rise in
interest rates is not likely in the absence
of a more robust increase in private sector
demand for credit.

Private Savings - In addition to weak
private credit demand, savings within the
business and household sectors have
increased significantly over the past
several years. Cash on business sector
balance sheets is currently in excess of $2
trillion, while surplus cash flow from
operations has also risen to record
levels. Savings within the household
sector have also increased rapidly during
the past three years. The combination of
depressed demand for credit along with
increased savings is supportive of low
interest rates.
(3) Inflation - It is crucial for investors to
differentiate between a sustained rise in
underlying inflationary pressures versus a
transitory spike in headline inflation triggered by
a surge in world oil and commodity prices. The
core Consumer Price Index (CPI) - which
measures the underlying trend in inflation - rose
at the slowest annual rate on record (+0.6%) in
Q4 of last year and has remained stable in recent
months at around 1%, even as headline inflation
accelerated sharply (see chart).
Economic Perspective – May 31, 2011

Pricing Power - The disparity between
these two measures of consumer inflation
is a manifestation of the lack of pricing
power within the business sector: An
inability of producers to pass through
higher input costs to the retail stage of
the pipeline. An abundance of unemployed
workers along with anemic wage growth is
also inconsistent with a sustained rise in
inflation in the medium term. My forecast
assumes a rise in inflation of only 2% in
both 2011 and 2012, which would support
continued historically low interest rates.
(4) Federal Reserve Policy - Correlation
analysis reveals that changes in the FOMC policy
rate are the single most important variable in
explaining changes in long-term interest
rates. My assumption is that the Federal Reserve
will not begin to raise its policy rate until the
second quarter of next year, and that a new
tightening cycle will unfold at a measured pace.
Sluggish economic growth, heightened financial
risk, persistent deflationary pressures, and
stubbornly high unemployment all suggest a
continued bias among policymakers toward
monetary ease for the foreseeable future.

Quantitative Easing - There is growing
concern among investors regarding the
imminent termination of FOMC large-scale
asset purchases and the impact on the
government bond market (see chart). My
assumption is that an end to quantitative
easing will have minimal impact on
market interest rates, for two basic
reasons: (1) The period during which QE2
was initiated was characterized by rising,
not falling, bond yields; and (2) In the
end, trends in market interest rates are
primarily determined by fundamental
factors:
Economic
growth,
inflation,
private credit demand, and changes in the
federal funds rate. These factors point to
continued
low
interest
rates
even
following the end of FOMC quantitative
easing.
U.S. HOUSEHOLD SECTOR DEBT
Year-Over-Year % Change
Quarterly 2003-2010
Source: Bloomberg
(5) Flight To Safety - As a classic safe haven
asset, U.S. Treasury securities benefit from
heightened systemic risk and instability within
the world economy, as investors flee the full
range of risk assets in pursuit of safety. Social
and political instability in the Middle East,financial
strains associated with the Eurozone sovereign
debt crisis, U.S. housing and banking instability,
and nuclear-related risks in Japan are likely to
persist for the foreseeable future, increasing the
demand for U.S. Treasury paper.
(6) Macro Perspective - From a broad macro
perspective, the fragile nature of the economic
recovery along with widespread systemic risk and
deflationary forces are consistent with low
interest rates. Following a post-bubble credit
collapse, history has clearly revealed that
economies have a strong deflationary tendency
and a bias toward lower, not higher, interest
rates and inflation. The implication is that
interest rates will remain at historically low levels
until there is meaningful rehabilitation within key
sectors of the economy, most importantly the
housing and banking sectors as well as the labor
market.
Economic Perspective – May 31, 2011
INTEREST RATE FORECAST
The primary conclusions with respect to my
forecast can be summarized as follows:

Market yields will remain directionless
for the remainder of this year and
fluctuate within a narrow range;

The FOMC will not begin
tightening cycle until 2012;

The Federal Reserve will implement
increases in short-term interest rates at a
moderate and measured pace;

Since market interest rates always
anticipate a shift in monetary policy with a
lead time of 3-6 months, bond yields
should begin to drift gradually higher
during the first half of next year;

The
transition
phase
to
long-term
equilibrium should occur over a multi-year
period with full normalization of interest
rates unlikely to occur until 2013.
a
new
Specific Rate Forecast - With the exception of
a 4-month period during late 2010, U.S. Treasury
yields have fluctuated within a range of 3% to
4% over the past two years, as measured by
the benchmark 10-year note. My forecast
assumes that Treasury yields will remain in this
same trading range through the middle of next
year. The trading range for the 5-year note
should be 1.75% to 3% over this same period.
Market yields on 10-year U.S. Treasury notes
should approach 3.75% by late this year and
4.5% by the end of 2012. A return to normal
equilibrium rates, which are estimated at 5.5%
for the 10-year note, appears unlikely until 2013.

U.S. QUANTITATIVE EASING
Federal Reserve Bank Assets
$ Trillions 2003-2011
Source: Bloomberg
Yield Curve - The Treasury yield curve
will remain in a historically steep slope
through all of this period, but will begin a
long-term flattening process during 2012
and 2013 as the Fed tightening cycle
unfolds. Return to a normal yield curve is
unlikely until 2013. Credit spreads in the
corporate bond market have narrowed
significantly over the past several years,
primarily
in
response
to
dramatic
improvement in the health of the
corporate sector. However, most of the
cyclical tightening in spreads has already
occurred, with only moderate narrowing
from current spread levels.
The bottom line is that a significant change in
interest rates is unlikely for the remainder of this
year and the first half of 2012. Federal Reserve
policy will remain on hold and market interest
rates are likely to remain directionless,
fluctuating within the same narrow trading range
of the past two years. While the FOMC will
eventually implement a new tightening cycle that
will trigger a significant rise in long-term interest
rates, this scenario is unlikely to unfold until the
middle of 2012.
Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that he spent 25 years at
CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the
Consulting Economist for Prudential Retirement. Bob has 37 years of investment experience.
The information provided is not intended to provide investment advice and should not be construed as an investment recommendation by Prudential
Financial or any of its subsidiaries.
Prudential Retirement, Prudential Financial, PRU, Prudential and the Rock logo are registered service marks of The Prudential Insurance Company of
America, Newark, NJ and its affiliates. Prudential Retirement is a Prudential Financial business.