Perspective on global economic and fixed income developments

Embracing the improbable

September 2016

Key takeaways:

  • Improbable doesn’t mean impossible, as illustrated by Brexit, negative interest rates overseas, and the Fed’s failure to hike interest rates so far in 2016.
  • Although economies in Japan, Europe, and many other overseas countries are rocky, we believe U.S. economic fundamentals seem reasonably sound.
  • Given the complex market backdrop, the Fed may not commit to raising interest rates until it’s convinced that such a move poses minimal risks.
  • Maintaining a well-diversified portfolio that includes fixed income can potentially help your portfolio when improbable events occur, and in our view, represents a crucial step toward long-term financial success.

Unexpected and improbable events occur in all aspects of our lives, particularly when it comes to investing. The current financial climate provides numerous examples of this reality. From negative interest rates in several parts of the developed world, to the U.K.'s unprecedented decision to leave the European Union (E.U.) in June, to U.S. interest rates remaining historically low for far longer than we once imagined, it's a whole new world out there. In spite of all these improbabilities, we believe that one particular point remains clear: U.S. bonds are just as important as ever.

Improbable doesn't mean impossible

As improbable as it may be, the U.S. economy isn't anywhere near where many pundits had predicted in the aftermath of the financial crisis. More than seven years into the official recovery, economic growth remains unremarkable, consumer prices are well contained, and short-term interest rates are really close to where they were at the end of 2008. Meanwhile, yields on government bonds have generally bucked conventional wisdom and fallen, instead of rising. What's behind this unusual series of events?

Lackluster economic growth in G7 countries has certainly played a predominant role, prompting certain central banks to adopt negative interest rate policies in a desperate attempt to stimulate growth. The notion that a country would actively push short-term interest rates into negative territory may have seemed improbable only a handful of years ago. Surely, such an effort would be expected to cause savers to pull their funds from local banks, stuff their mattresses full of cash, and the financial markets would face a meltdown. Yet this hasn't been the case.

If you're questioning the likelihood of someone accepting negative interest rates on a deposit, consider the situation in Switzerland. Swiss banks have started charging consumers to hold deposits instead of paying them interest, yet consumers aren't pulling out all of their cash. So although the thought of depositing $10,000 only to receive, with certainty, $9,950 one year later may have once seemed improbable, there's no escaping this present-day reality. Perhaps these savers view 10 to 20 basis points of negative yield as a small price to pay for safeguarding their deposits.

Switzerland isn't the only central bank employing negative interest rate policies. The Bank of Japan recently joined the below-zero bandwagon, with Sweden's central bank and the European Central Bank (ECB) having previously adopted such an approach. Their rationale is simple: they're forecasting that super-low rates will motivate consumers to spend more, and help companies to borrow more, hire more, and expand. This, they hope, will translate into faster growth.

The Brexit improbability

Europe, where lackluster growth has been an ongoing story since the financial crisis, is facing its own improbability. “Brexit,” the nickname given to Britain's vote to exit the E.U., sent shockwaves throughout the markets in late June. It's interesting that some forecasts just before the U.K. referendum estimated the outcome as essentially too close to call. Yet investors seemed shocked at the reality that the U.K. is now charting a course out of the E.U. Meanwhile, the Bank of England is desperately trying to avoid the country's economic collapse, having cut short-term interest rates to the lowest levels in centuries.

Furthermore, 10-year Treasury yields have fallen about 70 basis points (a basis point equals 0.01%) or so this year through the end of August—including an approximately 15 basis point decline since Brexit—since the Federal Reserve (Fed) raised rates at the end of last year, and in spite of the Fed's initial forecast for four interest rate hikes in 2016. So much for the misconception that U.S. bond yields couldn't possibly go any lower!

A different ballgame for the Fed

Unlike other G7 central banks, the Fed is trying to raise rates, a hope that they've been expressing off and on since late 2015. At a high level, the U.S. jobs market is cooperating, with the unemployment rate hovering below 5.0%, signs of wage pressures emerging, and the overall jobs market now seeming generally healthier.

However, one of the Fed's central mandates—and historically, one of the main reasons for raising interest rates in the first place—is to keep inflation in check, and inflation just doesn't seem to be much of a problem right now in the U.S. Factor in the tame inflation with merely modest economic growth, and this gives the Fed more flexibility regarding interest rate policies.

Nevertheless, a healthier economy in the U.S. compared with other G7 countries and the Fed's desire to resume raising rates means that yields on U.S. Treasuries are higher than yields on government bonds from other developed nations. The chart below illustrates this relationship, showing the comparatively attractive yields of 10-year Treasuries versus the yields of like-maturity government bonds from other countries.

An appealing yield

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

These higher yields enhance the international appeal of U.S. Treasuries. To buy these securities, investors overseas need to trade in their local currencies for dollars. This additional demand can lead to U.S. dollar appreciation, which makes U.S. goods and services more expensive overseas, reducing foreign demand and potentially acting like a brake on U.S. growth.

From this perspective, it's not surprising that the Fed is moving so slowly toward raising rates, and probably looking for the perfect moment before doing so. One of the things we think the Fed would like the least—and which would hurt its credibility the most—would be to raise rates only to have to lower them all over again a few months down the road if the U.S. economy stumbled. We think that this makes it even more possible for short-term rates to stay lower for longer.

Although economies in Japan, Europe, and other developed overseas countries are still somewhat rocky, U.S. fundamentals seem reasonably sound.

Key takeaways

With this improbable backdrop in mind, what do we see in store for the fixed income market over the near-term? Although economies in Japan, Europe, and other developed overseas countries are still somewhat rocky, U.S. economic fundamentals seem reasonably sound. Yet with the Fed highly sensitized to even small data changes, it's possible that disappointing numbers just prior to a policy meeting could derail any plans the Fed might have to raise rates. In addition, even though the Fed doesn't explicitly say much about stocks, a spike in volatility like the one we witnessed in late June after Brexit might keep the Fed on hold for longer. In our view, this all means that the Fed has much to consider, and that it may not fully commit to raising rates until it's convinced that such a move poses minimal risks.

In our view, this all means that the Fed has much to consider, and that it may not fully commit to raising rates until it's convinced that such a move poses minimal risks.

So what are the key takeaways for investors? Namely, that improbable doesn't mean impossible, so maintaining a well-diversified portfolio always makes good sense. We believe that a well-diversified portfolio includes an allocation to fixed income, and U.S. Treasuries in particular. These securities can help to balance the equity portion of your portfolio when it's most in need of support, and if you wait until an improbable market event occurs to diversify properly, you may miss out on some of the potential benefits. Moreover, in the current environment, bond yields could potentially stay low for much longer than previously anticipated, and we think this is particularly true for U.S. Treasuries. In short, fixed income is just as important now as ever!

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