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Have you seen interest rates lately?

While economic growth momentum is lending support to the Federal Open Market Committee (FOMC) to press forward with normalizing interest rates, international and domestic headlines keep Treasury yields trading within a range. 

The FOMC met recently on June 13th and raised the benchmark borrowing rate .25 percent for the second time this year. The Fed Funds are now set to target 1.75 to 2 percent. The more newsworthy update is that policy makers revised their overall forecast for 2018. They now estimate two more increases this year, upping the pace from their prior meeting in March. The new projection will see the Fed Funds rate climb to 2.375 percent at 2018 year-end. As for 2019, the agenda was left unchanged. Rates are set to climb to 3.125 percent – still reflecting the same three hikes expectation. “The main takeaway is that the economy is doing very well,” per Fed Chair Jerome H. Powell. In fact, stronger U.S. economic growth developments did push the 10-year Treasury yield to a year-to-date high of 3.11 percent back in mid-May. But broad market volatility has since sent the yield lower again. 

The first round of market turbulence came from abroad, where Italy’s populist parties recently joined forces to form a coalition government. The biggest task they face is addressing the Eurozone’s third largest economy’s severe fiscal and social challenges. At the same time, they must do so while complying with the European Union’s (E.U.) deficit guidelines, and with the Italian people souring on the union due to their constraints. The situation overseas raised anxiety levels for investors in euro-area stocks. And as is often the case, safe-haven flows into U.S. Treasuries intensified, causing yields to head lower. To add insult to injury, recent economic data showed the region hitting a soft patch, further unsettling equity markets. Although these fears have cooled off, the 10-year rate has remained below 3 percent due to tensions on trade negotiations. 

Just as the European clouds began to clear, a second storm quickly followed regarding trade disputes where tensions seem ever increasing. In response to U.S. levies on imports of aluminum and steel, Europe countered with imposing tariffs on $3.3 billion of American products. Trump reacted with threats for more taxes on European cars. Meanwhile, the U.S. is set to enforce tariffs on $34 billion of Chinese products on July 6th. And recently, President Trump stated he would tack on an additional $200 billion in new import taxes on top. To better combat the U.S. president’s threats, China is working to align itself with the eurozone nations. However, the two sides have additional conflicts of their own regarding fair trade that stand in the way of forming a stronger alliance. The ongoing heated talks are further anchoring down Treasury yields.

   

Several forces are independently and simultaneously in play that are tightening financial conditions on their own. Rising interest rates, Fed balance-sheet reduction, more protectionist policies, strengthening U.S. Dollar and higher levels of market uncertainty for example. The question is if these developments can become material enough to cause central bankers to doubt their current agendas? Solid domestic economic growth certainly suggests the Fed is okay to continue adjusting rates higher. But while these situations unfold, a possible range for the 10-year yield sees support at 2.5 percent and resistance at 3.1 percent. A convincing move above 3.2 percent would confirm to us that the secular bond bull market is likely officially over.     

Source: Bloomberg, data as of 06/28/2018.

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 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 4th quarter of 2018 will be 3.00% based on the past performance of the 30-year Treasury rates.  This is a .25% increase over what the discount factor was in the 3rd quarter of 2018.  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 3.038% for the quarter, then we will be able to still have the ExxonMobil discount factor round back down to 2.75%…right now we are at 3.05%.

If we had to predict is that we are going to be within the range of 2.9% up to as high as 3.3% for the quarter.  For planning purposes, we believe the fourth 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 3.038% means we need to have the 30 year go over that and stay there for longer to keep the discount rate at 3.0%.

Just as a little extra data, here is the ExxonMobil Discount factor for the grandfathered category going back to 2011:

  (Projected)

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 large rise in the discount rates for “nongrandfathered” category from first quarter to fourth quarter of about .70 to .75 basis points.  Fortunately, we have seen the segmented rates starting to slow between fourth quarter 2018 and first quarter 2019.

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.

Sincerely,


Bogart Wealth