Insights from Brett Wander

Chief Investment Officer
Fixed Income

Perspective on global economic and fixed income developments

Bond yields: Merrily we go 'round

Fall 2018

Key takeaways:

  • Short-term rates have risen with Fed rate hikes, but longer-term rates have been comparatively range-bound.
  • Moderate U.S. inflation is keeping longer-term rates in check.
  • Lower G7 bond yields than Treasuries and a possible end to rate hikes in 2020 are also constraining longer-term U.S. rates.
  • Maintaining sufficient liquidity and not over-reaching for yield are important points worth talking about with your clients. 

A seemingly endless stream of TV commercials and radio ads have been encouraging mortgage refinancing and car purchases before the Fed hikes short-term rates “again.” Don’t let your clients be fooled by the hype!

Although some rates have risen as the Fed has been normalizing its policies, yields on many longer-term U.S. fixed-income securities—from Treasuries to corporate bonds—have been relatively range-bound. For example, the approximately 3.0% yield on the 10-year U.S. Treasury as of late September is almost exactly where it was at the end of 2013, and well below levels in the early 2000s. Remember the early 2000s? That was when pundits began prognosticating that, “Rates have nowhere to go but up!” Little wonder then that some of your clients may think of their long-term bond experiences as similar to riding a merry-go-round, where yields gently rise and fall over time, but often seem to end up about where they started at the end of the ride.

In this edition of our quarterly fixed income insights, we discuss three factors that have been helping to keep longer-term U.S. rates in check: (1) moderate inflation, (2) international demand for Treasuries, and (3) an expected eventual end to Fed rate hikes. We also talk about the shrinking yield difference between short- and long-term Treasuries, which sets the tone for the broader U.S. bond market. We conclude with some actionable guidance designed to enrich fixed-income conversations between advisors and their clients.

Inch by inch, measuring inflation’s progress

Although consumer prices have been inching higher over the past year, the Fed has stated that inflation is currently at manageable levels. Consumers are acting with some restraint, generally avoiding the excessive spending often historically associated with the late stages of an economic cycle. In addition, despite near full employment, wages are still growing slowly. There are quite a few theories regarding why, from an evolution of the job mix amid technological disruption, to catch-up from the financial crisis, to a change in U.S. workforce composition. However, unless we experience broader wage growth, a meaningful and sustained pick-up in inflation seems unlikely. And without higher inflation, longer-term rates seem entirely capable of remaining range-bound.

Treasury yields top the G7 chart

Since the global financial crisis, major economies struggled to regain the level of economic prosperity that they enjoyed prior to the crisis. Weak economic growth and low inflation in the euro zone, and aging demographics in countries like Japan and China, have resulted in ultra-low rates globally.

In response, central banks around the world have been purchasing enormous quantities of government debt to further reduce borrowing costs and force capital into riskier investments. After years of this “quantitative easing” approach, the Fed, the European Central Bank, the Bank of England, and the Bank of Japan now own trillions of dollars of fixed income securities, collectively weighing down interest rates globally.

Treasuries continue to enjoy solid demand from global investors, anchoring yields on longer-term
U.S. bonds.

This is because investors seeking the highest credit quality and liquidity are forced to accept the lower yields resulting from the increased demand from these central banks. As investors evaluate fixed-income opportunities around the world, their options include 10-year government bond yields from Germany and Japan well below 1.0%, or U.S. Treasuries, with comparable bond yields hovering around 3.0%, as shown in the G7 government bonds chart below. Correspondingly, Treasuries continue to enjoy solid demand from global investors, anchoring yields on longer-term U.S. bonds.

An appealing yield

The higher yields of U.S. Treasuries make them attractive compared with bonds from other G7 countries, driving up international demand.

chart: federal funds rate vs. 10-year treasury yields

Policy by tweet: A foreign world

The traditional foreign policy playbook has been thrown out the window. President Trump has introduced us to policy by tweet, and the financial markets are having to adjust. History will judge the efficacy of the president’s approach, but one thing seems clear: the Treasury market has shrugged off the volatile political backdrop, sifted through the rhetoric and saber rattling, and has instead kept a watchful eye on the health of the U.S. economy and inflation.

Rate hikes won’t go on forever

There is a theoretical stopping point for the Fed, even if it’s still a ways off. The Fed recently hiked rates a third time in 2018, and futures contracts show a strong possibility of a fourth before the year is done. If this plays out, it would be the first time since 2006 that the Fed has hiked rates four times in the same calendar year. Where we go from there, however, could be a very different story.

Beyond 2019, the market isn’t currently pricing in any Fed rate hikes, which is the first time that’s been the case in several years.

The Fed’s dot plot—a graph of where actively voting Fed policy makers expect the federal funds rate will be in the future—suggests three hikes in 2019. The market doesn’t seem convinced, and is instead pricing in two hikes in 2019. Beyond 2019, the market isn’t currently pricing in any Fed rate hikes, which is the first time that’s been the case in several years.

The Fed’s grip on rates is relative

Relative to overnight interest rates, the Fed is widely considered the 800-pound gorilla in the room, but its influence over longer-term rates is comparatively nuanced.

The Fed’s main economic refinement tool involves adjusting overnight rates, specifically the federal funds rate. Adjusting this rate tends to have an immediate impact on the short end of the yield curve. This is because shorter-term instruments like the 2-year Treasury quickly adjust to the expected future path of overnight rates.

Let’s illustrate this last point with a relevant example. Since December 2015, the Fed has raised rates 8 times for a total of 200 basis points (2.0%). Over this period, 2-year Treasury yields have risen from about 1.6% to 2.8%. That’s approximately 100 basis points more than the corresponding yield change for 10-year Treasuries. This is a prime example of yield curve flattening and is illustrated in the chart below. If the Fed pauses as the federal funds rate approaches 3.0%, we wouldn’t be surprised to see 10-year Treasury yields stay in the 2.5% to 3.5% range.

Yield spreads contract

As shorter-term rates have risen while longer-term rates have been comparatively static, the yield difference between short- and long-term rates has fallen sharply.

Avoid an inverted-curve panic attack

With the Fed cautiously marching short-term rates higher, and plenty of rationale for range-bound longer-term rates, discussions about the flattening yield curve and the possibility for yields to invert are perhaps unsurprising. But would an inverted curve be something to worry about?

Conventional wisdom holds that an inverted curve, where shorter-term rates are above longer-term rates, portends a recession over the subsequent 6 to 24 months. However, we believe that the previously described factors are anchoring longer-term bond yields and reducing the yield curve’s predictive power where recessions are concerned.

Words of wisdom to share with clients

Markets can be resilient in the face of seemingly extreme headlines. While day-to-day results may reflect some volatility, markets have done a pretty good job of ignoring the noise, and instead pricing in risk appropriately. What we are seeing today is that earnings still play a big role in the stock market, while economic growth and inflation remain the driving forces behind the bond market. As a result, we think that your clients would be well served to tune out the media blitz, splashy headlines about yield curve inversions, and policy tweet after policy tweet.

Instead, ask your clients to focus on the big picture. Not over-reaching for yield takes discipline, especially when rates are low and additional risk seems the only way to maintain an income stream. Yet including too many lower-quality bonds in a portfolio can defeat some of the primary benefits that bonds can provide, an approach that makes even less sense in our yield-compressed environment. High-quality bonds maintain sufficient liquidity in a range of market environments, and help provide much-needed portfolio ballast when stocks fall. So even though bond yields may occasionally make some of your clients feel like they’re on a merry-go-round, Treasuries in particular should always play a role in a well-diversified portfolio.

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Brett Wander, CFA
Chief Investment Officer, Fixed Income
Charles Schwab Investment Management
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