We used to think that when the Federal Reserve raised interest rates, we would once again have a chance to invest our consumer nest eggs in low risk bonds that pay 4%-5%. It may be a daydream. Four upcoming changes in the financial market could hold rates down longer than we might expect. Lurking on the horizon are the maturing of $2 trillion in corporate debt, upcoming repatriation of $2.5 trillion in corporate earnings, a new tax policy that will encourage “less corporate debt,” and the potential of trimming the $4.5 trillion in the Federal Reserve’s (Fed’s) balance sheet. Each is big enough to shape yields available to consumer savings accounts – deposits, CDs, bonds and Treasury securities.
The Federal Reserve has kept interest rates low in the hopes that low cost investment money will encourage economic growth and the creation of new jobs and better incomes. With unemployment at 4.6% and inflation near 2.1%, the Fed has met its targets and will encourage interest rates to rise, preemptively blocking inflation from gathering steam. The Fed will continue raising rates so that by the end of 2017, the 10-year Treasury note will yield 3%. Further increases are expected so that short term rates will be at 3% in 2020, A typical yield curve implies that a 10-year Treasury Note will yield 5% in 2020. A 5% yield would be great news for consumer savers who have been insulted by sub-2.5% for years. The effect of a 5% yield will be reduced by a 2.3% forecasted rate of inflation.
“Less corporate debt” is a chilling theme implied in the upcoming tax reform package. It is implemented by denying interest charges deductions in federal taxes. The change would upset banks most of all, since they tend to use twice as much debt as equity. Non-financial companies use about twice as much equity as debt. To comply, a firm might buy back fewer shares, and use that money to buy its outstanding debt. This “less debt“ theme will push corporate bond prices up and yields down. The change would need to be phased in over 5-10 years or it will create havoc.
In the next 5 years, $2 trillion of corporate debt comes due and firms are expected to accelerate their debt issuance in the second half of 2017. The acceleration may be an effort to avoid the higher rates that the Fed will set. The reissue of maturing corporate debt will be tempered by the “less corporate debt” theme in the tax code. Again, that will somewhat decrease the number of bonds being reissued, and thus decrease their yield.
Also within the tax package before the Congress is an incentive to repatriate the $2.5 trillion in US company earnings parked in foreign countries. These cash piles are assets, not liabilities and could be reinvested in the US, used to pay down debt, loaned to another entity, or returned to shareowners. To the extent they are loaned out or used to repay debt, they will decrease bond yields.
The Fed holds $4.5 trillion in Treasury securities and mortgage bonds in its balance sheet. To convert those assets into cash, it would have to sell them, either to the public or to government (in effect, the Treasury would buy back the Note or Bill it originally sold to the Fed). But the federal government has no free cash to spend. So, when a Treasury security matures, the Treasury will just roll over the prior principal at the current interest rate. That should have little to no effect on the yield of other bonds.
So, the respectable yields we hoped for at the end of the great recession may be illusory. The “less corporate debt” policy, the repatriation concession, and corporate debt replacement may shave points off what we can expect for nest egg yields. Until the federal government gets its deficits under control, the Fed’s balance sheet trimming is just a fantasy.