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Interest Rates Outlook – Q1 2020

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    More and more the U.S. economy appears to have transitioned into the later stages of the business cycle. The unemployment rate has dropped to levels last seen in 1969, and wages are steadily rising. Strong labor markets and increasing pay are symptomatic of mature phase environments. The good news is a near fully employed America bodes well for spending and corporate earnings. However, anxiety levels are intensifying on fears the end is near – especially with the current expansion marking the longest on file. But somethings are different this time around too.  

    Late in the game, we typically experience rising inflation. Additionally, central banks respond by upping interest rates to prevent economic overheating. Instead, 2019 saw the Federal Reserve reduced rates three times to provide “insurance” U.S. economy will remain stable for longer. Policy makers cited concerns over “cross currents” from trade disputes and uncertainty from political events abroad. 

    Monetary officials overseas have taken measure of their own to counter weak local growth. They adjusted their benchmark interest rates to sub-zero levels for example. Investors abroad effectively pay a premium (versus collect income) when investing in their bonds. The result has created a global community starved for yield which pushes overseas debt traders to redirect funds towards our higher (and positive) yielding assets, and in turn, raises the demand for Treasuries and further lowers our rates. Said differently, U.S. Treasury yields are being artificially anchored down. How this development will unfold and what ripple effects it will have remains a bit unclear.  

    One of the main factors for interest rates is inflation expectations. For price growth to accelerate we need more economic activity and wage increases. On that front, the U.S. economy seems destined to expand for a while longer, however, at a more moderate pace around 2%. Well employed and financially healthy consumers, who make up roughly two-thirds of our Gross Domestic Product, should keep the economy at least stable. However, geopolitical uncertainty and slow global growth tempers the pace.   

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    In such an environment, rates staying lower for longer projects to be the base case. We could see yields move higher / lower over the medium-term, but the current search for income and benign inflation expectations mitigates the odds of any spikes. At the same time, per the Fed’s very own guidance, it would take a significant deterioration in economic fundamentals to see them materially move the fed funds lower from here.

    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 first quarter and second quarter of 2020 discount rate are 2.25%. 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. 

    As long as we maintain an average below 2.2237% for the quarter, then the ExxonMobil discount factor will round down to 2.00%…right now we are at 2.04%. For planning purposes, we believe the third quarter 2020 discount rate will decrease to 2.00%.

    Just as a little extra data, here is the ExxonMobil Discount factor for the grandfathered category going back to 2016:

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    For those in the “non-grandfathered” category, which is anyone born after 1958 or or hired after 1998, 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. 

    Here is the updated projections we have for interest rates.  The official numbers are now announced and listed below, or can be found here:

    https://www.irs.gov/retirement-plans/minimum-present-value-segment-rates

    The first quarter 2020 rates are the lowest they have ever been.  For any employee using the “non-grandfathered rates”, the IRS now published the official second quarter rates, which are indicating a slight increase between first quarter and second quarter 2020.  

    We are now modeling projections for the third quarter.  The first month of the quarter has no impact on the following quarters discount rates.  Said another way, only February and March will determine third quarter rates.  January is giving us an indication of direction.

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    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

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