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Each year for the last few years we've been taking a hard lookat the drivers behind interest rates and conveying our thoughtsabout where they will go in the future. When we last looked atwhere rates were headed last December, we surmised that withoutsubstantial global economic growth that rates wouldn't move higher.Well … they didn't move higher…they moved a lot lower. With theonset of a global pandemic, interest rates went on a wild ridethrough the first half of 2020. That ride has had far-reachingeffects on investors, especially those with interest rate-sensitiveliabilities like corporate pension sponsors.

So how has the current economic environment affected interestrates and what could cause them to change course between now andthe end of the year? In this article, we'll look at:

• The drivers of short- and longer-term interest rates;
• How those drivers have affected rates year-to-date; and,
• What could cause rates to change for the rest of 2020?

Market background

Treasury rates have fallen sharply since 2018, where the 10-yearreached roughly 3.25%.  We began 2020 at approximately1.50% on the 10-year and have since fallen to all-time lows below0.60%.  Corporate bond rates started 2020 lower than wherethey began in 2019 and have fallen further so far in 2020.

With the onset of the global pandemic in March, the FederalReserve cut the Fed Funds Rate, which is the "overnight" interestrate that banks borrow the Fed at, from 1.50% – 1.75% to 0.00% –0.25%. This is in line with where interest rates were held from2009-2015.

Given that the Fed isn't currently interested in taking itsFunds Rate negative, at this point there's nowhere left to go butup (hopefully).  However, that won't happen until theeconomy recovers and is rooted on solid ground.

With the global economic upheaval that began in Q1, the world'smajor central banks started to infuse cash into the economy viaQuantitative Easing ("QE") measures, which involve central banksbuying securities such as Treasuries, mortgage-backed bonds,corporate bonds and even in some places, equities. The Fed beganits full-scale buying programs in late March and April to "supportliquidity and the flow of credit to consumers and businesses."These programs, along with fiscal and monetary programs around theglobe, total an unprecedented 30% of Global GDP, year-to-date.

Equity markets have also been on a wild rollercoaster so far in2020. Q1 proved to be one of the worst quarters in history, whileQ2 was one of the best. The volatility in the equity markets(domestic and international), demand for safe haven assets, and theoutlook for growth are why we continue to see Treasury ratessitting at or near all-time lows.

Corporate bond yields have also dropped substantially but havebeen buoyed up somewhat due to widening credit spreads – which isanother indicator of the shaky outlook that the market is factoringinto current yields. Credit spreads on high-yield bonds havenarrowed since their widest levels in late March, but are stillpricing in risk that reflect the higher probability ofdefault/bankruptcy.

Short-term interest rates

The main driver of short-term interest rates comes from theFederal Open Market Committee's ("FOMC") setting of the Fed FundsRate. The Fed's mandate from Congress is to "promote effectivelythe goals of maximum employment, stable prices, and moderate longterm interest rates." Stated differently, the Fed has a dualmandate of achieving full employment while controlling the level ofinflation. The Fed's main tool for accomplishing its objectives isthrough controlling the level of the Fed Funds Rate.

As mentioned above, the Fed took swift action in March to reducethe Fed Funds Rate to 0.00% – 0.25%, the same level it maintainedin the aftermath of the Great Financial Crisis of the late 2000's.While inflation expectations continue to be well below the Fed'starget of "at or near 2%," unemployment, however, has touchedlevels not seen since the Great Depression.

A big question now is whether all those lost jobs will come backat all – we believe that at least several percent of the increasein the unemployment rate will be the result of "permanent" joblosses that will take years to recover vs. those jobs that canreturn more quickly when the direct impact of the pandemicsubsides.

Accelerated technology will make some jobs obsolete or changethe way that work is done. This re-shaping of the workforce is acommon feature of recessions and, while painful, is ultimatelyhealthy.  We will not know for some time which jobs willreturn quickly and which will be lost permanently, but the Fed willbe focused on those permanent job losses and its need to supportthe economy while it creates new ones.

Unemployment and excess capacity are deflationary forces, andhigh unemployment combined with deflation or at least "low-flation"will allow the Fed to most likely keep short-term rates low formany years.

What would cause the Fed to change course?  Ifunemployment declines much more quickly than expected, or ifinflation expectations increase significantly and unexpectedly,then the Fed could be forced to raise interest rates.

Long-term interest rates

"Long term rates" are the yields available on  bondswith over 10 years of length.  Although shorter rates areimportant for the economy and tend to get more publicity, it isthese longer rates that are more directly relevant to pension plansand other institutional investors who also invest in longermaturity bonds.

Longer-term US Treasury rates reached historic lows in 2020 withthe 10-Year falling below 1.00% in March and bottoming out justover 0.50% shortly thereafter. The 10-Year yield has hoveredprimarily between 0.60% and 0.80% ever since. The 30-Year alsofound new lows when it fell just under 1.00% in early March.

Longer-term rates tend to move with the following:

1. Economic conditions;
2. inflation expectations;
3. and expectations of the Fed Funds Rate over the next severalyears (plus/minus a Term Premium which we are assuming stays aroundzero for purposes of this article).

For the near term, long Treasury rates should remain rangebound, with the yield on 10-year bonds below 1%, given that the Fedis likely to hold short-term rates near zero for several years.

1. Economic conditions. Historically,the 10-year Treasury has followed nominal GDP (nominal GDP is realGDP, which is what is generally reported in the media, plusinflation).  While these don't always move in lockstep,they do tend to trend in the same direction.

Currently, nominal GDP is near 2% (Q1'20), while as of thewriting of this article the 10-Year Treasury is at approximately0.60%.   With near term GDP growth in question, andinflation expected to remain low, it makes the prospect oflong-term rates rising substantially in the near-term improbable.As we've seen historically, even with nominal GDP taking asignificant plunge, Treasury rates have managed a smoother paththat is directionally consistent over time.

What we've seen so far this year was a significant drop inlong-term rates.  The question now remains whether theywill go lower (even approaching the negative rates we see in Europeand Japan) or stabilize and begin a process of moving higher aslong-term nominal GDP growth prospects improve. While beyond thescope of this article, the implications that negative rates onlong-term bonds would have on investors and pension plan sponsorsare far-reaching.

Based on economic expectations, we would anticipate long-termrates to stay range bound to a new, lower range. We expect yieldson 10-year Treasuries to move between 0.50% – 1.00% and on 30-yearTreasuries to stay between 1.00-2.00%.

2. Inflation expectations. There is astrong relationship between long-term interest rates and expectedinflation. Higher inflation leads to higher nominal interest rates,but with a lag.

Current expectations of inflation (which can be calculated bysubtracting the yield of Treasury Inflation Protected Securitiesfrom the yield of normal Treasuries of the same maturity) implies along-term inflation level of around 1.50%, which is below the1.75-2.00% we have seen over the past several years.

How might we see a pickup in expected inflation? Expected inflation could rise if the following occurs:

• The economy starts to overheat on the back of fiscal andmonetary stimulus.
• The economy bounces more quickly than expected because of amajor breakthrough with the pandemic.

Right now, most central banks are more concerned about deflationthan inflation. Many, including the Fed, would be likely to allowexpected inflation to be higher than their target for some timebefore taking action such as reversing QE or raising interest ratesto try and bring inflation under control.

3. Expectations for the Fed Funds Rate. Withthe Fed's moves in March, and its view on negative rates,there's hopefully nowhere to go but up from here with Federal FundsRate.  The main question on everyone's mind is when theFed will begin its tightening process.  This timing hassignificant implications for both short and long-term rates.

The market is currently pricing in no rate increases through2021.  The Fed will need to see the economy on a strongfooting before it begins the process of removing stimulus— and given the virus, the timing will be some time from now.

Credit spreads

Credit spreads are largely driven by equity market volatilityand default expectations. While we are in the midst of a deeprecession and the fundamentals of many companies are seriouslyimpaired, credit spreads on all but the weakest companies are notmuch wider than they were at the beginning of the year. The primaryreason for that is that the Fed stepped in to provide a fullbackstop to any company with an investment grade credit rating asof late March. The risk of bankruptcy for these companies, at leastover the short-term, has been alleviated.

The Fed has also provided support to non-investment gradecompanies and to smaller companies of all types, all of which hashelped credit spreads to recover.

While spreads are still a bit higher than they were to start theyear, they are not nearly as high as they would be otherwise. Thereis still elevated default risk in the sectors hardest hit by thepandemic such as energy, travel and physical retail. And there arepotential long-term negative effects from the steps the Fed hastaken.

However, for now investors with significant holdings oflong-term investment grade bonds, such as many corporate pensionplans and insurance companies, can breathe a little easier as weexpect the Fed backstops to be sufficient to stave off a largenumber of bankruptcies.

The flip side of this is that tighter credit spreads also meanslower pension liability discount rates, and therefore higherreported liability values.

Pulling it all together

Given all of the drivers of interest rates, where do we seerates going from here – especially the yields on long-termcorporate bonds used to set pension liability discount rates?

What we are likely to see from the Fed: Giventhe scale of unemployment, the likely timetable for full economicrecovery from the pandemic and low expected inflation, the Fed willmost likely hold short-term rates at zero for several years.

What we are likely to see for longer-term interestrates: Longer term interest rates are a function of:expected real GDP growth, inflation expectations, and expectationsof the level of the Fed Fund Rate.  While real GDP growthcan return to trend within the next couple of years as the directeffect of the pandemic subsides, we expect inflation expectationsto remain low and for short-term interest rates to remain near zerofor several years.

We therefore expect long-term interest rates to stay in theirnew, lower, range for the foreseeable future. These rates will stayin this lower range until unemployment reaches levels where the Fedcan begin to increase short-term interest rates.

Credit spreads will fluctuate with equity markets, defaultexpectations and the timing of removal of any backstops the Fed hasin place.

Long-term corporate bond yield should be flat to lower asTreasury rates will be range bound and credit spreads shouldmigrate tighter. Central bank programs should support furthertightening of credit spreads through the rest of this year, unlessthere are other factors (e.g. geopolitical events, prolongedpandemic, and the US election).

For corporate pension plans with liability values linked tolonger-term, high-quality corporate bond yields, we would notexpect any meaningful near-term improvement in funding levels tocome from significantly rising interest rates, and indeed can seerates moving lower from here.

What could change the outlook? The currentoutlook will continue to be affected by the pandemic. If thepandemic is not brought under control, then the resulting weakenedeconomic conditions will put additional downward pressure on rates.Conversely, development and faster-than-expected deployment of aneffective vaccine would be a catalyst for quickly improvingeconomic conditions and support higher interest rates. However, faster-than-expected recovery is still a 2021 event.

What investors can do

There are always unknowns when it comes to interest ratemovements. Based on the current economic environment and thepandemic, low long-term rates are likely here to stay for at leastthe next 1-2 years, with near-zero short-term likely for severalyears after that. For investors, especially those with interestrate-sensitive liabilities like corporate pension plan sponsors,revisiting asset allocation strategies is paramount. Investors willneed to take a holistic look at their expected return and riskprofiles along with liquidity needs and decide if they need to dosomething different to have success over the long-term.

Michael Clark is a Managing Director andConsulting Actuary in River and Mercantile's Denver office and is thecurrent President of the Conference of ConsultingActuaries.

Phil Gorgone is a Managing Director andHead of Investments in River and Mercantile's Bostonoffice.