January 8, 2019
It could be argued that October of 2018 marked a memorable moment for all in the business of interest rate forecasts. For starters, minutes from the U.S. Federal Open Market Committee (FOMC) showed officials intensified their debates on adjusting rates higher. Additionally, the committee estimated that 3% is about the neutral level in rates – where policy is neither stoking nor slowing the economy. But it was Fed Chairman Jerome Powell who shocked markets in his post meeting comments.
While some members of the FOMC argued for less restrictive levels, others were growing concerned the economy was at risk of overheating. Ultimately, Powell came out and stated rates were far from neutral, and that the committee could very well raise past the 3% mark given the economy is doing “very good.” What immediately followed was the market’s violent protest and utter disagreement with the Chairman as global assets began selling off. As a result, in subsequent messages, the policy setting body was quick to revise and soften their language – potentially suggesting their initial words were (perhaps) more hawkish than originally intended.
December’s meeting made matters worse in the eyes of market participants. Seeing U.S. Gross Domestic Product (GDP) continued to expand at a solid healthy pace, the FOMC stuck with their plans to gradually adjust rates higher. They lifted the benchmark rate .25% that month for the fourth-time on the year. The move itself was long anticipated, however, investors were disappointed when the Fed stayed the course with their agenda for more increases. In fact, per derivatives trading, investors are pricing zero hikes for 2019, and are calling for a reduction in 2020. The two are clearly at odds and will soon require some conflict resolution.
The Treasury yield curve provides a visual form of this misunderstanding between the Fed and fixed income investors. The gap in rates between U.S. 2-year and 10-year sovereign debt has been one of the most popular and sensitive topics in news headlines. Short-term rates, which are influenced most by the decision makers, have now climbed to a point where they are nearing the levels of longer-term rates, which are driven by market expectations – primarily inflation. Historically, if near-term yields surpass longer-term yields, it has traditionally led to a recession within the next 6 to 18 months (hence market anxieties).
U.S. 10-Year Yield less U.S. 2-Year Yield (5YR Chart):
*Source: Bloomberg as of 12/31/2019
The disconnect between the committee and market participants will be a development to closely monitor this year. As DOT-PLOTS indicate, FOMC is targeting rates around 2.85% in 2019, and just north of 3% for 2020. However, both the Fed Funds Futures and Overnight Interest Swaps (or the markets expectations) are heading in the other direction, staying flat in 2019 and moving back to 2% in 2020. The question now is if global assets (and maybe the U.S. President) can convince the Chairman that liquidity and market volatility trump inflation and overheating risks.
FOMC Projections (green-line) versus Market Expectations (white-line):
*Source: Bloomberg as of 12/19/2018.
What are the implications 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 born before 1958 and hired before 1998, 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 were born after 1957 or hired after 1997, 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 1st quarter of 2019 will be 3.00% based on the past performance of the 30-year Treasury rates, and we now know the second quarter discount rate will also be 3.0%. 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 the ExxonMobil discount factor will round down to 2.75%…right now we are at 2.989%. For planning purposes, we believe the third quarter discount rate will either decrease to 2.75% from the 3.0% level, or it will stay flat at 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, it is difficult to easily see the overall impact when short term rates are moving at different speeds, or even different directions. To address this, we estimate an equivalent “single rate” that makes comparison easier. In summary, there is a rise in the discount rates for “nongrandfathered” category from first quarter to second quarter of about .24 to .25 basis points.
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.