The first half 2017 saw volatile 30-year bond yields that climbed as high as 3.21% in the first quarter, fell as low as 2.7% in the second quarter, and has since trended back up again and stands at 2.9% as of 7/14/2017. Developments in Washington, D.C., in macroeconomic data and in Fed policy actions are to blame as markets reacted to their headlines.
Initially, President Trump’s pro-growth policies resulted in expectations of higher business cycle expansion, inflation and interest rates. Equity markets and bond yields bounced sharply higher in what was coined the “Trump Trade.” At the same time, the Fed was also busy executing their rate hike schedule given a strong growing economy.
As the year progressed, Congress eventually proved true to form and hard-lined presidential campaign promises quickly turned fluid. Growth expectations and the “Trump Trade” reversed course completely, and interest rates came under pressure. Additionally, with yields abroad negative to near zero, foreigners instead purchased higher yielding U.S. Treasuries – further bidding up bond prices (and pushing yields lower) even though the Fed was raising rates.
*Provided by Bloomberg, and as of 07/14/2017.
Perhaps the most interesting message is in the analysis of nominal versus real treasury rate curves. In the yield curve chart below, you will see two sets of comparison line graphs – longer nominal (inflation included) rate curves and shorter real (excluding inflation) rate curves.
*Provided by the U.S. Department of the Treasury, and as of 07/14/2017.
One of the top story lines in the first half of 2017 was yield curve flattening. Comparing the two nominal rate curves above, the two longer lines marked by dots, its indeed clear that short term rates went up (as the Fed increased rates) while longer-term rates came down slightly. The common diagnosis offered in the headlines was that the flattening curve was indicative of potential economic weakness ahead as evidenced by recent softness in inflation data.
On the other hand, observing real rates, the set of shorter lines marked by triangles, which excludes the effects of inflation, it is also evident that real rates inched higher YTD – implying a growing economy. In fact, corporate earnings, the ultimate test of an expanding economy, has been growing. And with employment closer to full capacity, wage growth should follow, along with consumer spending and inflation as stated in Fed minutes. In the words of Janet Yellen, “weak inflation data was influenced by transitory factors.” Additionally, comments from ECB president Mario Draghi suggest an inflection point is nearing where easy accommodations will shift to monetary tightening soon, the results of which should see sovereign rates abroad offer competition to domestic rates and remove the heavy anchor placed on U.S. treasury yields.
So, what are the implications this has for ExxonMobil households?
As many of you know, there are two categories of employees when it comes to their pension/lump-sum options. Those who were over age 55 and had worked for over 15 years of service on or before December 31, 2012, they take 95% of the quarterly average of the 30-year Treasury Rates, these individuals are given the title of “Grandfathered” category. For those who had not over age 55 or did not have 15 years of service on or before December 31, 2012, they use a combination of short term, intermediate term, and long term corporate bond rates, and as you could guess, these individuals are considered “Non-grandfathered.”
For the grandfathered individuals, we know that the discount factor for the 4th quarter of 2017 will be 2.75% based on the past performance of the 30-year Treasury rates. The question is, where do we go from here? If we had to make a projection on 30 year yields in the short-term, rates are likely to remain volatile as headline risk continues to influence markets, especially on light summer volumes. However, in the medium to longer-term, macroeconomic fundamentals point to higher rates as “transitory” factors should pass, global economies gain further strength and global central banks taper accommodations.
As long as we maintain an average below 3.026% for the quarter, then we will be able to still have the ExxonMobil discount factor round down to stay at 2.75%…right now we are at 2.905%.
If I had to predict is that we are going to be within the range of 2.7% up to as high as 3.15% for the quarter. For planning purposes, we believe the first quarter discount rate will be right on the bubble between 2.75% and 3.0%, it is all going to be based upon what the average is for the quarter, so every day below 3.026% means we need to have the 30 year go over that and stay there for longer to bring it up to 3.0%.
Just as a little extra data, here is the ExxonMobil Discount factor for the grandfathered category going back to 2011:
For those in the “nongrandfathered” category, we checked the spread of grandfathers vs. non-grandfathered. That only checks the long-end of the yield curve. And, it is the other end of the yield curve that has made the most significant shift.
The pension/lump sum conversation is just one part of any household’s financial plan. We encourage all to review this in conjunction with their financial advisor. Please feel free to reach out if you have any questions.