Have you seen interest rates lately? – February 28, 2018 Update
Due to the rapid increase in interest rates over the past few weeks, we wanted to provide an updated report, and provide our thoughts on what impact this has on discount rates for anyone considering a lump sum option for their pension.
Market participants began the year with little faith policy makers would stay the course for 3 interest rate hikes in 2018, and instead priced in just 2 increases. The core thesis for investors centered on inflation. Prior to February of this year, the story of long-term yields was little more than the story for inflation expectations, which headlines repeatedly referred to as benign. Even the Fed began to doubt, initially citing inflation trends as “transitory,” and latter sounding slightly more concerned by stating it was “persistently low.” What transpired throughout 2017 was a flattening yield curve as markets grew concerned central bankers were getting ahead of themselves by gradually raising rates in the face of low price growth. But then came the Labor Department’s report on February 2nd, 2018.
U.S. employers added 200,000 jobs this past January, keeping the unemployment rate steady at 4.1 percent, the lowest since 2000. The median forecast was 180,000. However, the real surprise was that average hourly earnings rose a more-than-expected 2.9 percent year-over-year, the most since June 2009. Given that policy makers have long stated tight labor markets would eventually create wage pressures and inflation along with it, stocks and bonds sold-off aggressively in the days following. Market participants were quick to reprice their inflation and interest rate expectations upward. They are now predicting the monetary committee will in fact at minimum honor their guidance for 3 increases, and could possibly deliver 4 adjustments.
The 10-year treasury yield started the year at a low of 2.4 percent, and then climbed rapidly after the report. Yields went as high as 2.95 percent, before falling back down due to subsequent inflation data. Economic reports showed the U.S. Consumer Price Index rose a more-than-expected 0.5 percent month-over-month in January. But, year-over-year figures painted a much more modest picture with growth rates of 1.8 percent cooling-off inflation fears, which has since seen the 10-year stabilize around 2.85 percent as of this writing. While the market’s sensitivity to inflation is rising, other forces are also at work.
A confluence of factors is now exerting pressure on yields: firming inflation, fiscal expansion, and subtle messages for less accommodations from major central banks. In addition to the inflation vulnerabilities, U.S. Treasury officials are dumping mass amounts of debt on the open market to offset loss of revenue from tax reforms and extra budget expenses. And minutes from the European Central Bank meeting showed policy makers in Europe are leaning more and more towards removing a pledge to expand bond purchases if needed. The net result of these developments is likely to keep rates volatile and steadily pushing higher as supply outpaces demand, and as foreigners begin to question their need to seek higher yields in the U.S., especially as the Euro has strengthen relative to the US Dollar.
Some have speculated the U.S. Federal Reserve could scale back interest rate increases due to recent market volatility. However, in a written testimony to the House Financial Services Committee, Jerome Powell stated the Fed will continue to gradually raise rates as growth outlooks remain strong. “In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis,” he said. Regarding the recent stock market correction, “we do not see these developments as weighting heavily on the outlook for economic activity, the labor market, and inflation. Indeed, the economic outlook remains strong.”
Although we do acknowledge that the U.S. Economy’s maturity cycle has progressed, now showing signs of wage growth, inflation pressures, and other typical late inning behaviors, we still think rates will continue to ascend over the coming quarters. We think the next several months will see yields fluctuate within a narrow range, with the range likely to shift slightly higher.
Treasury yield curve has shifted upward in 2018
Source: U.S. Department of Treasury. As of Feb. 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 2nd quarter of 2018 will be 2.75% based on the past performance of the 30-year Treasury rates. This is the same rate as for the 4th quarter of 2017, and for the 1st 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.
Due to the recent spike in 30 Year Treasury Rates, the ExxonMobil discount factor for “Grandfathered” individuals will round up to 3.0% if we continue to maintain an average rate of 3.0893…right now we are at 3.16%.
A prediction of the 4th quarter 2018 interest rates is premature at this time, but we do believe that 30 Year Treasury rates are going to reflect an overall upward trend. For planning purposes, we believe the fourth quarter discount rate will be right on the bubble between 3.00% and 3.25%. The fourth quarter discount factor is all going to be based upon what the average is for the second quarter, so every day below 3.289% means we need to have the 30 year go over that and stay there for longer to bring it up to 3.25%.
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. You will notice that there is a pretty sizable movement between second and third quarter rates as all three segments have increased.
We are projecting the “single rate equivalents” for someone retiring at age 60 to increase up to 3.41% up from 3.03%, and for someone retiring at age 55 up to 3.47% from 3.10%. Just a reminder, that if you fall into this age group, your Benefit Commencement Date (BCD) needs to be no later than June 1, 2018 in order to take advantage of second quarter discount rates.
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.