U.S. government bonds officially signaled caution in the third quarter. Fixed income investors typically expect to receive more yield as they extend maturity dates given the less certain nature of the future. However, we recently saw long-term rates abnormally move lower than short-term rates, triggering what the industry terms a yield curve inversion.
Inverted yield curves carry historical significance because of their ability to predict recessions. In the past, whenever the event occurs, the economy eventually contracted within the next couple of years. Stalling economic growth tends to push rates lower. News outlets have been quick to direct the blame towards slowing global growth brought on by geopolitical developments. We agree, but we also advise some pause to reinforce one of our key messages of late: “headlines will continue to invite volatility.”
Inverted yield curves have in fact preceded every recession since the 1970’s. At the same time, they also operate with a significant lag and have proven difficult to time. Additionally, although we never like to advocate the “this time it’s different” philosophy, there are some unique factors that are obstructing the yield curve forecasting model that merit some awareness.
One key phenomenon we have witnessed for some time is international money chasing the better relative value of U.S. debt. The world total for negative-yielding bonds (where investors pay to keep money secure) has ballooned to 17 trillion dollars.
Therefore, an investment with higher (and positive) yield such as the U.S. can appear far more attractive and draw significantly more demand. Citizens of struggling economies abroad are creating strong pressures that maybe artificially pushing U.S. yields lower – some economists speculate by as much as 1% to 1.5%. The U.S. Federal Reserve (Fed) has also been an active factor.
The Fed met in September and reduced their benchmark rates .25% to target a range of 1.75% to 2%. It was the second time this year rates have been decreased. “We took this step to help keep the U.S. economy strong in the face of some notable developments and to provide insurance against ongoing risks,” were Jerome Powell’s words. Perhaps slightly more notable is that Powell left open the possibility for “a more extensive sequence of cuts” but made clear he does not anticipate a need for deep cuts this year.
Furthermore, the Fed’s recent meeting showed officials were split over the necessary adjustments to rates going forward. Five voted to keep rates steady. Five saw a quarter-point reduction needed, while seven called for .5% of easing by year-end, of which half was just delivered.
The probability of recession is a key item to watch. Odds have indeed increased, but we still believe a full-blown contraction will be avoided in the near-term. We think the U.S. economy will expand for a while longer, however, at a more moderate pace just shy of 2% versus the +3% levels we saw in 2018. Well employed and financial healthy consumers, who make up roughly two-thirds of our Gross Domestic Product, is the reason we think the economy should remain OK. At the same time, mixed economic signals, a split committee and unusual developments from abroad, will likely continue to see more rate volatility ahead.
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” category, we know that the discount factor for the 4th quarter of 2019 will be 2.75% based on the past performance of the 30-year Treasury rates, and we now know the first quarter 2020 discount rate will also be 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 2.2448% 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 second 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 2015:
For those in the “non-grandfathered” 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 DECREASE in the discount rates for the “non-grandfathered” category from the fourth quarter to the first quarter of about .58 basis points. For planning purposes, we are seeing the segments remaining volatile, although the numbers that drive the discount rates for the second quarter 2020 will be based solely off November and December interest rate activity, October won’t impact effective numbers.
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.
