Much lower, says Senior Fixed Income Strategist Doug Drabik – if central banks continue to intercede.
Yields around the globe have fallen precipitously in the last year largely as a consequence to struggling global economies and central bank responses. This has had a significant impact on the U.S. Treasury yield curve, a line that plots the yields of U.S. Treasury securities.
Generally, the yield curve is positively sloped, as it rewards investment in longer-term maturities (with greater market risk) with relatively higher rates of return versus those with shorter-term maturities (less market risk). However, under certain economic circumstances, this curve can become negatively sloped and thus “inverted” (i.e., when bonds with shorter-term maturities have higher yields than those with longer-term maturities). When the curve is inverted, it often signals that something is amiss. This is why inverted yield curves are so often considered an indicator of a looming economic recession or an end to an economic cycle.
In the U.S., yields on Treasuries with long-term maturities have recently fallen more than those with short-term maturities, causing several key points along the Treasury yield curve to invert. The spread between the 2-year/10-year Treasuries inverted briefly for 12 days at the end of August, while the 3-month/10-year spread has remained inverted for a little over four months. While such inversions are often alarming to investors (as evidenced by the volatility immediately following the 2-year/10-year inversion), several key factors would suggest that the U.S. yield curve has been influenced to a greater degree by certain global circumstances that bear mentioning.
The lack of inflation and slowing economic growth around the world (especially outside of the U.S.) has prompted central banks to assume increasingly accommodative monetary policies. This has included cutting interest rates and implementing asset purchase programs in an attempt to stimulate slumping economic growth and inflation. The asset purchase programs directly influence lower global interest rates. Through quantitative easing, the world’s four major central banks (the Federal Reserve, the European Central Bank, the Bank of Japan, and the People’s Bank of China) have swelled their combined balance sheets to ~$19.4 trillion (up over 200% since the start of the Great Recession). In many markets (most notably, Europe and Japan), negative interest rates have become commonplace and total worldwide debt with negative yields has recently crested at over $17 trillion.
The current global interest rate environment and growing worldwide uncertainty has, in turn, swayed investors into both a flight to quality and search for yield. The U.S. bond market, albeit historically low in yield, boasts comparatively high interest rates and a strong credit standing. Thus, the subsequent demand for U.S. debt has been a significant headwind to higher interest rates. Volatility along the yield curve has been rewarding for investors that took on duration. For example, the 30-year Treasury (3.375% coupon, maturing 11/15/48) that closed 2018 at around $107 was valued at $132 in early September. That equates to a total return of approximately 32.3%. Metaphorically, longer-duration bonds have been on fire, and although many bond investors don’t employ bonds as total return investments, the total returns have outperformed most other asset classes this year.
Market uncertainty culminates with the often-asked question “how low can interest rates go?” Many pundits suggest that rates have a barrier or minimum level at which investors will engage. Clearly, we have not reached such a point, nor does anyone know whether one actually exists. Overseas, the European Central Bank declared its willingness to use any and all means at its disposal to stimulate the economy, as evidenced by its recent announcement of a new round of monthly asset purchases.
Domestically, the U.S. may be swayed toward choices that prevent the dollar from getting too strong and/or interest rates too varied from global rates. Even with our still-growing economy and robust employment, the Federal Reserve has lowered rates twice this year. The bottom line is that global influences will impact interest rates more than the economy here in the U.S. As long as the world’s central banks continue to intercede, it is very plausible to conclude that interest rates can go much lower.
Despite lower interest rates, it is imperative that investors maintain asset allocation discipline. Individual bonds provide consistent income, predictable cash flow, and greater protection of principal. These features hold true at any interest rate level. As shown during recent bouts of volatility this year, longer-duration assets fared extremely well. Being cognizant of reinvestment risk is just as important (if not more important) than duration risk in the current environment. In order to weather the volatility, investors must stay true to their long-term financial plans.
All expressions of opinion reflect the judgement of Raymond James & Associates, Inc., and are subject to change. Investing in international securities involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.