In my last post, I looked at equities in 2023, and argued that while they did well during 2023, the bounce back were uneven, with a few big winning companies and sectors, and a significant number of companies not partaking in the recovery. In this post, I look at interest rates, both in the government and corporate markets, and note that while there was little change in levels, especially at the long end of the maturity spectrum, that lack of change called into question conventional market wisdom about interest rates, and in particular, the notions that the Fed sets interest rates and that an inverted yield curve is a surefire predictor of a recession. As we start 2024, the interest rate prognosticators who misread the bond markets so badly in 2023 are back to making their 2024 forecasts, and they show no evidence of having learned any lessons from the last year.
Government Bond/Bill Rates in 2023
I will start by looking at government bond rates across the world, with the emphasis on US treasuries, which suffered their worst year in history in 2022, down close to 20% for the year, as interest rates surged. That same phenomenon played out in other currencies, as government bond rates rose in Europe and Asia during the year, ravaging bond markets globally.
US Treasuries
Investors in US treasuries, especially in the longer maturities, came into 2023, bruised and beaten rising inflation and interest rates. The consensus view at the start of the year was that US treasury rates would continue to rise, with the rationale being that the Federal Reserve was still focused on knocking inflation down, and would raise rates during the yearl. Implicit in this view was the belief that it was the Fed that had created bond market carnage in 2022, and in my post on interest rates at the start of 2023, I took issue with this contention, arguing that it was inflation that was the culprit.
1. A Ride to Nowhere – US Treasury Rates in 2023
It was undoubtedly a relief for bond market investors to see US treasury markets settle down in 2023, though there were bouts of volatility, during the course of the year. The graph below looks at US treasury rates, for maturities ranging from 3 months to 30 years, during the course of 2022 and 2023:
2. The Fed Effect: Where’s the beef?
I noted at the start of this post that the stock answer than most analysts and investors, when asked why treasury rates rose or fell during much of the last decade has been “The Fed did it”. Not only is that lazy rationalization, but it is just not true, and for many reasons. First, the only rate that the Fed actually controls is the Fed funds rate, and it is true that the Fed has been actively raising that rate in the last two years, as you can see in the graph below:
Nominal Interest Rate = Expected Inflation + Expected real interest rate
If you are willing to assume that the expected real interest rate should converge on the growth rate in the real economy in the long term, you can estimate what I call an intrinsic riskfree rate:
Intrinsic Riskfree Rate = Expected Inflation + Expected real growth rate in economy
In the graph below, I take first shot at estimating this intrinsic riskfree rate, by adding the actual inflation rate each year to the real GDP growth rate in that year, for the US:
I will not oversell this graph, since my assumption about real growth equating to real interest rates is up for debate, and I am using actual inflation and growth, rather than expectations. That said, it is remarkable how well the equation does at explaining the movements in the ten-year US treasury bond rate over time. The rise treasury bond rates in the 1970s can be clearly traced to higher inflation, and the low treasury bond rates of the last decade had far more to do with low inflation and growth, than with the Fed. In 2023, the story of the year was that inflation tapered off during the course of the year, setting to rest fears that it would stay at the elevated levels of 2022. That explains why US treasury rates stayed unchanged, even when the Fed raised the Fed Funds rate, though the 3-month rate remains a testimonial to the Fed’s power to affect short term rates.
3. Yield Curves and Economic Growth
It is undeniable that the slope of the yield curve, in the US, has been correlated with economic growth, with more upward sloping yield curves presaging higher real growth, for much of the last century. In an extension of this empirical reality, an inversion of the yield curve, with short term rates exceed long term rates, has become a sign of an impending recession. In a post a few years ago, I argued that if the slope of the yield curve is a signal, it is one with a great deal of noise (error in prediction). If you are a skeptic about the inverted yield curves as a recession-predictor, that skepticism was strengthened in 2022 and 2023:
As you can see, the yield curve has been inverted for all of 2023, in all of its variations (the difference between the ten-year and two-year rates, the difference between the two-year rate and the 3-month rate and the difference between the ten-year rate and the 3-month T.Bill rate). At the same time, not only has a recession not made its presence felt, but the economy showed signs of strengthening towards the end of the year. It is entirely possible that there will be a recession in 2024 or even in 2025, but what good is a signal that is two or three years ahead of what it is signaling?
Other Currencies
The rise in interest rates that I chronicled for the United States played out in other currencies, as well. While not all governments issue local-currency bonds, and only a subset of these are widely traded, there is information nevertheless in a comparison of these traded government bond rates across time:
Unlike the start of 2022, when five currencies (including the Euro) had negative riskfree rates, there are only two currencies in that column at the start of 2024; the Japanese yen, a habitual member of the low or negative interest rate club, and the Vietnamese Dong, where the result may be an artifact of an artificially low government bond rate (lightly traded). Understanding that riskfree rates vary across currencies primarily because of difference in inflation expectations is the first step to sanity in dealing with currencies in corporate finance and valuation.
Corporate Borrowing
As riskfree rates fluctuate, they affect the rates at which private businesses can borrow money. Since no company or business can print money to pay off its debt, there is always default risk, when you lend to a company, and to protect yourself as a lender, it behooves you to charge a default or credit spread to cover that risk:
Cost of borrowing for a company = Risk free Rate + Default Spread
The question, when faced with estimating the cost of debt or borrowing for a company, is working out what that spread should be for the company in question. Many US companies have their default risk assessed by ratings agencies (Moody’s, S&P, Fitch), and this practice is spreading to other markets as well. The bond rating for a company then becomes a proxy for its default risk, and the default spread then becomes the typical spread that investors are charging for bonds with that rating. In the graph below, I look at the path followed by bonds in different ratings classes – AAA, AA, A, BBB, BB, B and CCC & below – in 2022 and 2023:
Looking to 2024
If there are lessons that can be learned from interest rate movements in 2022 and 2023, it is that notwithstanding all of the happy talk of the Fed cutting rates in the year to come, it is inflation that will again determine what will happen to interest rates, especially at the longer maturities, in 2024. If inflation continues its downward path, it is likely that we will see longer-term rates drift downwards, though it would have to be accompanied by significant weakening in the economy for rates to approach levels that we became used to, during the last decade. If inflation persists or rises, interest rates will rise, no matter what the Fed does.
