My colleague Rick Rieder has provided a great deal of insight on the near-term direction of interest rates, and specifically, when and under what circumstances the Fed might make its first move toward higher rates. He also touches on how an aging population affects the economy and markets here, a topic I find fascinating as a municipal bond investor.
Why my fascination? One reason is that municipal bonds tend to be a buy-and-hold choice for our typical investor. Munis generate a stream of tax-exempt income that has made them a bedrock in planning for retirement income. And their low-volatility nature tends to make them very conducive to longer holding periods. For that reason, we like to look at long-term trends to see how they might impact the municipal market.
So while we’re sharply attuned to the short-term rate outlook, we’re also interested in what the interest rate backdrop might look like over the next several years. And what are we seeing? Not a significant amount of change.
If you consider that the Fed is using inflation and the employment picture as key gauges of interest rate policy, then you would have to believe the central bankers are not going to get too aggressive in their rate movements if these two measures remain muted. And demographic developments suggest they are likely to remain just that.
Inflation: No Big Spenders
When it comes to inflation, we have to ask ourselves, where will it be generated in the current economic cycle? Baby boomer spending had a significant inflationary impact on the economy from 1969 to 2007. The first boomers hit age 23 in 1969, kicking off a pivotal lifetime income/spending cycle that was perpetuated by younger boomers for years to follow. (Anecdotally, peak spending typically occurs at age 46). The 10-year Treasury yield averaged 5.1% from 1928-2013. If you remove the period of boomer-driven inflation, that average drops to 3.1%.
I should also note that the boomer “boom years” were characterized by the build-up of a great deal of financial leverage. Today, post-crisis, we live in a deleveraging environment. We’re also in a world where the younger generation, the millennials, are in a different place than the boomers were at the same age. Findings from Pew Research show millennials have higher levels of student debt and lower levels of wealth and personal income than the two generations prior — and that translates into little to spend to fuel the economy. The bottom line is that, absent a vital inflation engine in the current cycle, the Fed will have little reason to raise rates aggressively.
Employment: No (Job) Vacancy
In regards to the employment picture, the statistics indicate that people 65 and older are working longer. In fact, the percentage of workers who expect to retire after age 65 has steadily crept up over the years from 11% in 1991 to 33% in 2014, according to the Employment Benefit Research Institute (EBRI)’s 2014 Retirement Confidence Survey. 10% of those surveyed said they don’t plan to retire at all. This trend presents challenges for the employment picture. Unemployment rates for the 20-24 and 25-29 age groups are 13% and 9%, respectively, well above the national average of 5.9%. As younger workers are crowded out, job prospects are stunted. And if that means younger generations have little money in their pockets, once again we’re left searching for that new regiment of spenders. For their part, boomers have passed their spending phase and are now in or saving for retirement
Putting it all together: Interest rates are at historically low levels and will have to rise. But the amount of that rise is likely to be limited. In fact, headwinds for employment growth and no clear catalyst for rising inflation are likely to keep interest rates subdued for a while. The Fed itself has alluded to a relatively gentle rate-hiking cycle with the peak for the target federal funds rate likely to be below the long-term average.
How long could “gentle rates” last? It’s hard (impossible really) to say. Until jobs and wealth shift to millennials, economic growth (and rates) is likely to remain subdued. By some estimates, however, millennials already outnumber boomers and gen Xers, so when they hit their earning/spending/consuming stride … the impact could be big.
For muni investors, that means the longer end of the curve should remain the place to be for incremental yield pick-up for the foreseeable future. Although longer maturities have gotten expensive recently, after the market’s stellar 2014 run, they should continue to represent long-term value for traditional muni bond investors.
Sources: BlackRock, S&P Municipal Bond Index, U.S. Census, EBRI