Wednesday, August 21, 2019
Interesting Interest Rates
Anthony C. Kure, CFP®

Anthony C. Kure, CFP®

Managing Director of Northeastern Ohio Market, Principal
Wealth Management, Cleveland - Akron

Interesting Interest Rates

When people talk about investing, bonds typically take a back seat to stocks. 

Typically the Steady-Eddie asset class, bond interest payments and return of principal never seem quite as exciting as the flashy world of the stock market.  At cocktail parties, coffee shops, and backyard barbeques the question “What’s going on with the stock market?” might be asked ten times before anyone would ask “What’s going on with the bond market?” 

But talk of the bond market has picked up considerably given the current global economic landscape, the recent decline in bond yields, and the accompanying price increases of bonds worldwide.

Where We Stand Today

In general, developed economies are experiencing decelerating growth and even contraction in some cases. While the long history of business cycles tells us this is a periodic and normal occurrence (hence the term cycle), what is unique are the broader secular trends that have driven bond yields to historic lows. Slowing or contracting economies have almost always resulted in declining bond yields, but the depth and speed of the rate declines today are more notable. The recent trend can be attributed to the combination of secular slowdown in the global economy mixed with more acute headwinds from the US-China trade war, electoral uncertainty, a potentially messy Brexit, and several other geopolitical brush fires (Hong Kong unrest, South Korea vs. Japan, North Korea). 

These economic crosswinds have resulted in some bizarre bond price moves. It’s been estimated that about $15 trillion of global debt yields less than zero. And according to Deutsche Bank Securities, 43% of bonds outside the United States have a negative yield. This means investors are getting LESS back on their bonds than their purchase price if they hold the bond until maturity. Much of this is due to central banks flooding their economies with liquidity to support growth and investment, but inflation and growth remain muted at best.

Here in the U.S., we have not been immune to lower yields. The 30-year Treasury dipped below 2% for the first time in history (as of Thursday, August 15th, 2019). In addition, the yield curve (a chart of yields across the maturity spectrum) has inverted, as the 10-year Treasury note yields less than the 2-year. Even more head-scratching is the recent price move in some other governments’ very long-term bonds. The longer the maturity of the bond, the greater the price increase when interest rates decline. The 100-Year Austrian bond is now yielding a paltry 1.1%, and the price has increased 50% in the last three months! 

What’s driving rates lower? 

There are many factors contributing to lower yields. The economic outlook is softening somewhat. Trade policy is damaging business activity and confidence to invest for the long term. This sentiment is reflected in an increasingly skeptical and volatile stock market. Adding to this mix of factors, the Federal Reserve is beginning the process of lowering interest rates for the first time since the 2008 Financial Crisis. As a result of all this, investors are seeking the safety of bonds as a haven from volatility and uncertainty. Undoubtedly, overseas investors are flocking to U.S. Treasuries as a way to find income.

Could rates go below zero in the United States?

Yes. There’s no reason to believe that in a serious economic crisis the Fed wouldn’t explore following several of the world’s largest central banks in their strategy to provide debt with negative yield.

What are the investment implications?

The bond market “law of physics” states that as bond yields fall, bond prices go up. To put it simply, if rates continue to fall, then bond returns should continue to be quite strong. The dramatic decline in yields that we have experienced over the past twelve months has pushed bond returns well into double-digit territory. While it’s unlikely we repeat the stellar returns of the past year, we are also not fearful of an abrupt shift higher. In order to see interest rates rise meaningfully, one must assume that the Fed resumes tightening monetary policy – an unlikely development in the face of structural economic headwinds like trade policy, demographics, and high government debt levels.

Bottom Line

The rapid price moves we’ve recently experienced have a history of overshooting the reality of the situation. Such shifts tend to be more emotional and reactionary rather than empirical and prudent. Knowing this, we hesitate to extrapolate the recent trends to a permanent shift in the global investment landscape. For this reason, we do not manage bond portfolios based on speculation about interest rates but instead focus on quality and diversification. Most importantly, we work with clients to maintain adequate exposure to bonds to ensure portfolios have the downside protection needed for long-term success through any market environment.

Find more practical advice on a wide variety of wealth management topics by exploring our JIC Blog: Beyond the Numbers library.