Are rising Federal Reserve-driven interest rates synonymous with disaster for the bond market?
This is a common question I’ve been fielding in recent weeks—and I’ll cut quickly to the chase. The answer is no—but it might be tough to tell that from recent media coverage associated with rises in interest rates.
To understand why interest rates hikes don’t unequivocally spell disaster for bond holders, it’s helpful to start with a basic question: Why do interest rates rise in the first place? While there can be many individual factors at play, it usually boils down to one overarching reason: Interest rates typically rise because the bond market expects that economic activity will continue to expand and, therefore, that a higher rate of growth will lead to higher inflation expectations.
Put another way, interest rates reflect the bond market’s assumption of what the real economic growth rate is, plus the expected inflation rate. The more volatile of these two components is usually the projected inflation rate.
Going back to September of 1981, the 10-year U.S. Treasury yield was 15.84%. While it’s impossible to know precisely what the market’s expectation for real economic growth was back then, we can assume that it was somewhere around 3%—as that was the average real gross domestic product (GDP) growth rate for the 30 years ending on Dec. 31, 1980. But 3% does not equal 15.84%. So this means that interest rates were likely driven up by very high inflation expectations.
Flash forward to today. Because of a multitude of demographic and productivity factors, we believe that the average real GDP growth rate for the next 20 years will likely linger slightly below 2%. Case in point: The U.S. Federal Reserve (the Fed) now has an inflation target of 2%, as measured by the core personal consumption expenditures (PCE) index. In highly simplistic terms, this would mean that at equilibrium, the U.S. 10-year Treasury rate would be in the 3.5 to 4% range. That’s not even on the same playing field as where things were in the fall of 1981.
Can short-term raises grind the economy to a halt?
Given all this, one might say, “Okay, I understand that in the long run, rates are not likely to spike to high levels, but what about in the short term?”
The first thing to remember is that we are about to enter the tenth year of this credit cycle, as measured from when credit spreads last peaked, which was near the end of the Great Recession. It’s likely that the next peak in credit spreads will occur during our next recession.
Typically, this late in the credit cycle, the labor market is at full employment—which it appears to have reached now. Full employment is essentially the point at which there are fewer qualified unemployed potential employees than there are job openings. This forces employers to start increasing wages to attract already employed workers. This upward tick in wage inflation is the type of inflation that the Fed responds to—by raising interest rates in an effort to slow economic growth and associated new job creation, all with the goal of curbing wage inflation.
William McChesney Martin, Jr. once famously said that the job of the Federal Reserve is “to take away the punch bowl just as the party gets going”—implying that the Fed is often the cause of recessions. While I’m not sure that’s a totally fair characterization, it’s true that Fed rate increases are often associated with the eventual onset of recessions. Basically, in an effort to slow the economy, the Fed usually raises short-term interest rates on a frequent basis. This has the net effect of slowing down the economy to the point where it becomes vulnerable to a recession.
This time around, things are a little different. The Fed has been raising short-term interest rates since December of 2015, but in contrast to previous times, it’s done so very, very slowly. By the time the Fed’s next meeting rolls around in January, it will only have raised the cash rate by 1.25% in two years. The primary reason for this? The inflationary pressure that usually manifests itself this far into a credit cycle has not arrived yet and interest rates have stayed persistently low. These low interest rates are also due in part to monetary policies from outside the U.S.—for example, quantitative easing by both the European Central Bank and the Bank of Japan—which have helped put downward pressure on U.S. interest rates.
Peering into the crystal ball
So, what about those next couple of years? At Russell Investments, we feel there is a chance that inflation will spike sometime before the next recession sets in. What we strongly believe is very likely to happen, however, is this: the Fed will continue raising interest rates in the short term—with the majority of the increases occurring in the next 12 months. Beyond 2018, we envision any rate hikes to be few and far between. As John Bellows, portfolio manager at Western Asset Management, notes, “Subdued inflation will ultimately limit how much the Fed raises rates. After a few more hikes next year, the Fed could be close to done for this cycle with a terminal funds rate of between 2 and 2.5%.”
In our view, this will be enough to slow the economy in the first part of 2019 and heighten the probability of a recession. In a recession, interest rates typically fall, as investors flock to bonds for the safety they offer relative to equities. In addition, the Fed itself typically starts cutting short-term interest rates in an effort to spur increased economic activity, exerting further downward pressure on interest rates. Last but not least, equities tend to sell off aggressively.
This is why we are of the belief that rates will have a tough time getting north of 3% before the next recession. In the words of our senior investment strategist, Paul Eitelman: “Although there will be upward pressure on longer-term interest rates as inflation moves toward the 2% target and other central banks start to tighten monetary policy, the level to which interest rates will be able to rise in this cycle is quite muted. We expect that the highest the 10-year U.S. Treasury yield is likely to get to in this cycle is between 2.75% to 3.0%.”
That would equate to a rise of 50 to 70 basis points (bps) over the next couple of years. It’s worth pointing out that in the fourth quarter of 2016 alone, interest rates rose by 85 bps. While this did lead to unattractive quarterly bond returns, it did not set off a disaster for the bond market—far from it, in fact.
That’s the beauty of bonds. Most investors own bonds—Treasuries in particular—in order to preserve capital and offset equity risk. In a world where global equities are expensive—especially in the U.S.—we believe that maintaining exposure to bonds is a wise move. While the short-term returns may not be overly impressive, our expectation is that they will be satisfactory enough to help investors pull through the next equity bear market. Disaster? Hardly.
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