On July 8th, 2016 the United States 10-year Treasury closed yielding 1.36 percent – its lowest level in modern history. Investors were buyers of safe haven assets for most of the year, but a final bounce following the ‘Brexit’ vote pushed yields to all-time lows. Since then, interest rates have risen but remain at historically low levels. The fall in rates last year, however, was not an altogether new occurrence. Outside of small, short-lived increases, the ten-year U.S. Treasury rate has trended downward for most of my adult lifetime marking one of the longest bond bull markets in history.
Paul Schmelzing of Harvard University recently recounted nearly eight hundred years of global bond market cycles on a Bank of England posting. He examined various bond market reversals occurring in the world’s rotating financial centers from Venice in the 13th century to the United States today. The current bull market for bonds began in the U.S. in 1981 after interest rates spiked in order to combat persistently high inflation. In the 35-year period since, interest rates fell more than thirteen percent.
Today’s bull market in the U.S. ranks as the third longest bull market for bonds in history and the second largest drop in interest rates. As a consequence, the Barclays Aggregate Index, representing the core U.S. bond market, returned 5.5% per year – after adjusting for inflation –from 1981 to the end of the third quarter in 2016 (Figure 1). But this bond bull market looks increasingly likely to end. Interest rates have risen gradually from the lows in 2016 on signs inflation is picking up, and the U.S. Federal Reserve (Fed) is clearly, step by step, becoming more hawkish. This is natural, given domestic and global economic growth which are both firming up and broadening.
Economic data in the United States has pointed to an economy gradually picking up over recent months. Importantly, faster growth is occurring while the labor market nears full employment and a new U.S. Presidential administration promises fiscal stimulus. The fulfillment of this promise is unclear, but steps towards normalization of monetary policy are rightfully high on the agenda for the Fed. The Fed`s own `Dot Plot’ offers a signal for where investors can expect the path of interest rates, or more specifically the Federal Funds Rate. It represents each Fed committee member’s view on where the rate should be at the end of the each respective calendar year. The most recent one, points to three rate hikes this year.
In both 2015 and 2016, the Dot Plot overshot its actual tightening, but 2017 could be the year in which actual tightening will match expectations - or even exceed it - if significant fiscal policy stimulus is realized. And yet, three to four rate hikes a year, at 25 bps increments, would be considered a `gradual` tightening cycle by historical standards. The market currently only anticipates two hikes.
The environment following the last noted bond bull market (1920 – 1945) offers many characteristics analogous to today. Most notably, we were some years removed from a great financial crisis, and rates had become lower for longer. In the ten year period following the bull market from 1945 to 1955, intermediate-term interest rates rose very slowly, but intermediate-term government bonds returned less than the cost of goods increased. Those bonds fell an average of about two percent per year when adjusted for inflation. A decade or so later, in the late 1960’s and early 1970’s, an inflation reversal – where the price trend of goods and services changes direction and moves higher – left some bondholders particularly impaired in real purchasing power terms.
Today, we think it is reasonable to conclude that U.S. government bond yields have recorded their low point in the most recent bull market cycle. Therefore, investors should expect some combination of the aforementioned events, where an uptick in inflation and slowly rising interest rates will pose headwinds for bond markets.
While we do see inflation rising from low levels, we do not envision a repeat of the 1970s where runaway inflation propelled interest rates to historic heights. For one thing, numerous central banks have adopted very clear inflation targets. For another, demographics in the developed world point to a reduced appetite among older generations to spend as they did in their prime earning years. And finally, technological change should continue to curb costs.
In our portfolios, we are underweight government bonds. In the U.S. we feel it is likely that the ten-year Treasury yield will continue to rise gradually as markets adjust to a more hawkish Fed – potentially breaching 3% this year. For government bond investors, a rising yield environment such as this, from historic lows, presents a headwind; meanwhile, the same trend would provide a tailwind to commodity sensitive assets and floating rate notes. Historically, short duration high yield bonds have held up relatively well when Treasury yields inch higher. In the near to medium term, we have a moderately positive outlook for US stocks while remaining cautious about the possibility of a large move in either direction. We are hesitant, however, where it comes to overseas investing, with Europe being an area of particular concern.
By Jae Yoon, Chief Investment Officer, New York Life Investment Management
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