Vanguard's Joe Davis on interest rates, the US economy and what the Federal Reserve will do next

Joe Davis is Vanguard's global chief economist and head of the Vanguard Investment Strategy Group, which helps set the Valley Forge, Pa., fund behemoth's asset allocation strategy. Mr. Davis spoke with InvestmentNews about the outlook for interest rates, the economy and the Federal Reserve's next actions. InvestmentNews: What's your outlook for the 10-year Treasury note? Joe Davis: We haven't changed our outlook in the past couple years. We're looking at 2.5% on the 10-year Treasury. We did anticipate modest rises in short-term rates, given Federal Reserve policy, but that doesn't mean long-term interest rates will rise. And it's not just our cyclical view on the economy. There are long-term forces that drive the 10-year rate as well. I personally would be shocked if the 10-year got to 4% over the next decade. We tend to look over all periods of time, and we're able to collect data for two centuries. What we've found is that the 70s and 80s were the outliers rather than the norm. Without that period, the average for the 10-year T-note has been closer to 3%. There would have to be a fundamental change of inflation drivers. IN: So where are we in the economic cycle? JD: I think we're right about midway. I don't think a recession is imminent, some unfortunate event aside. On structural basis there could be problems with government debt levels, but the rest of the economy, from autos to construction, is in decent shape. The greatest risk is from overseas: The U.S. economy is likely to remain resilient. IN: Some economists say that the Fed is likely to let the economy run hot for a while — in other words, err on the side of increased growth and inflation. Do you think inflation is a danger? JD: I don't think the economy will run hot. I'm more gratified to see the more pernicious deflationary forces moderate, whether it's in commodities or excess manufacturing capacity. The Fed wants to see 2% core inflation, and that's likely to occur. But (Fed chairwoman Janet) Yellen threw cold water on the notion of letting the economy run hot: She used the word "unwise" in her speech in February — that was a clear shot across the bow. We think there's a high probability the Fed will raise rates in June, and that there will be two hikes this year. That will still leave the fed funds rate below 2%. We'll see more deliberations about tapering the size of the Fed's balance sheet, which keeps rates low. The Fed will (and should) tread lightly with regard to tapering the balance sheet. They are going to be cautious and deliberate in how they do this, likely by reinvesting less. We could see talk about that as early as the economic symposium at Jackson Hole. IN: Essentially, you're calling for a flatter yield curve. That's not great for banks. JD: I think we will continue to see a flattening of the yield curve. It won't invert. Ironically, at the margin, that outlook means there's more risk in near-term bonds. IN: So you're not recommending buying short-term bonds. How about credit quality? JD: You want some Treasuries in case there's a flight to quality. We also like high-quality corporate bonds and high-quality overseas bonds on a hedged basis. We have modest expectations. We don't expect outsized returns. We're reluctant to have too much exposure to high yield at these levels. So we're more inclined to match duration to credit exposure. IN: Does the size of the federal debt concern you? JD: It has not been in my top five list of worries. Longer-term, debt is the seminal economic political and social issue of our lifetime. It's not sustainable. But for it to be a crisis now we'd need to see investors demand a higher risk premium, i.e., yield. And we'd need to see a viable alternative bond market and reserve currency.