Why Are Government Bond Yields Still Low, and Are They Going up Any Time Soon?

Transcription

1 September 015 MONTHLY MARKET INSIGHT Why Are Government Bond Yields Still Low, and Are They Going up Any Time Soon? The fear of rising interest rates, which has clouded investors psyches for years, has yet to be realized. In fact, forecasters annual predictions of higher rates have been wrong in all but one year since 007 (FIGURE 1). Even the yield spikes during the taper tantrum of 01 and the taming of Europe s deflation fears in June of this year have been short-lived. So it s time to ask: Why have rates stayed so low, and will this trend persist? Interest rates in developed market government bonds have remained low for several reasons, including slow global economic growth, accommodative central bank policies, a globally competitive yield environment, a weak commodity cycle, and an aging population. In this month s commentary, I explain why I believe the world is in for a long stretch of low interest rates: Major central banks are likely to remain accommodative Developed market yields are likely to stay anchored to the lowestyielding region Commodity prices should remain weak, keeping inflation and rates low Populations in the developed world are aging Nanette Abuhoff Jacobson Managing Director and Asset Allocation Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds Fig 1 FIGURE 1 Government Bond-Yield Forecasts Have Consistently Been Wrong 5 4 U.S. 10 Year Yield Forecasts and Actual (%) Forecast Actual Central banks directly impact interest rates, and I expect their easy monetary policies to remain in place around the world. Nanette Abuhoff Jacobson Sources: FX4Casts, Bloomberg NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE Year Real Yields (%)

2 Fig 1 Major Central Banks Are Likely to Remain Accommodative Central banks directly impact interest rates, and I expect their easy monetary policies to remain in place around the world. The Federal Reserve s (Fed s) path toward normalizing rates will be slow and gradual, regardless of when exactly the first hike takes place. I believe the Fed has met the employment objective of its dual mandate, but has so far failed to achieve the other half: an inflation target of approximately %. The headline consumer price index 1 is near zero, but that has been held down by low oil prices. Core inflation which excludes food and energy and is important to the Fed because it believes it is a leading indicator of headline inflation is under %. I also think the Fed will remain accommodative, in part because the strong U.S. dollar has essentially been doing the Fed s job for it. A stronger U.S. dollar tightens financial conditions by making exports costlier and imports cheaper, helping to tamp down inflation. A model that the Fed uses to estimate the economic impact of a stronger dollar indicates that Fig a 10% increase in the exchange rate, which ripples through the economy as importers, exporters, and consumers adjust, could adversely impact gross domestic product (GDP) by.75% within two years. Developed Markets Are Likely to Stay Anchored to the Lowest-Yielding U.S. 10 Year Yield Region Forecasts and Actual (%) 5 Bond investors scour the world for the Forecast most attractive Actual places to deploy capital. This makes it unlikely for the yields of any one developed market to decouple and rise 4substantially above others. Earlier this year, fears of euroarea deflation held down U.S. Treasury yields despite better relative growth fundamentals in the U.S. In June, when German bund yields rose by.8% as deflation fears dissipated, U.S. yields moved higher too. As FIGURE shows, the U.S. is the high yielder across developed government bond markets. Until growth or inflation picks up substantially in one of these regions, or confidence of China avoiding a hard landing returns, yields will remain low across the board, even in the event of stronger U.S. growth. 1 FIGURE U.S. Real Yields Are the Highest in Developed Markets Year Real Yields (%) Additionally, with many emerging markets (EM) in economic turmoil and volatility recently spiking because of events in China, the Fed will not want to exacerbate the situation. Long periods of low interest rates are not unprecedented, especially when accompanied by government intervention. Between 1945 and 1957, the U.S. government supported government bond markets with aggressive purchases to prevent interest rates from soaring amid high debt levels accumulated during WWII. For their part, the Bank of Japan (BOJ) and European Central Bank (ECB) should continue with their aggressive quantitative easing (QE) programs, while the Bank of England (BOE) is delaying hiking. The BOJ is buying 80 trillion yen per month and could increase those purchases later this year because Japan s GDP and inflation data Fig have disappointed recently, and the consumer remains relatively weak. The BOE was expected to be the first major central bank to hike rates, but weaker inflation and labor data have stayed its hand for now. The ECB s commitment to maintaining liquidity and supporting the eurozone economy has been unwavering. It is making purchases totaling 60 billion euros per month through September 016. In its recent meeting, the central bank acknowledged the downside risks to growth and inflation from external sources and opened the door to expanding its QE program. Real yields remove the inflation-expectation component of the government bond yield which allows for easier comparisons across regions. Past performance is not indicative of future results. Source: Bloomberg U.S. Crude Oil Inventories and Oil Prices Commodity Prices Should Remain Weak, Keeping 10 Inflation and Rates Low 110 1,900 Commodity prices are positively correlated with interest rates in developed markets for two main reasons. First, 100 commodities are a key inflation input. Rising commodity 1, prices generally lead to higher inflation, while falling prices drive inflation lower. For the past several years, 80 1,700 the commodity cycle has been weak and prices have 70 been falling. When inflation falls, investors demand for 1,600 yield falls, driving interest rates lower as well. Second, 60 1 Oil Price ($/barrel) (RHS) A consumer price index measures changes in the price level of a market basket of consumer goods and services purchased by households. 1,500 Gross domestic product is the monetary value of all the finished goods and services produced within a country s borders in a specific Inventories time period. (millions of barrels, LHS) Quantitative easing is a type of monetary policy used by central banks to stimulate the economy when 1,400 standard monetary policy has become ineffective. 1/09 1/10 1/11 1/1 1/1 1/14 1/ Japan UK /14 /14 6/14 9/14 1/14 1/15 /15 6/15 9/15,000 Germany U.S Fig 4 P 0% 5% 0% 15% 10% 5% 0% 00

3 1 U.S. 10 Year Yield Forecasts and Actual (%) Forecast Actual MONTHLY MARKET INSIGHT periods of very low inflation usually associated with weak commodity prices are the same periods in which central banks intervene to stimulate economic activity by lowering rates. Another way in which low commodity prices lead to low inflation is via emerging market currencies. Lower 0.0 commodity prices drive EM currencies lower because many EM countries export commodities, so as commodities weaken, their currencies tend to weaken as well. Weak -0.5 EM 1 currencies mean EM exports are cheaper in countries with stronger currencies. Thus, in effect, EM countries with weak currencies export deflation to the developed world, -1.0 dampening interest rates everywhere. 10-Year Real Yields (%) I expect 1.0 Germany the trends U.S. that have contributed to weak commodity Japan prices to UKcontinue: oversupply, slow economic -1.5 growth and currency devaluation in China, and a strong 1/14 U.S. 0.5 /14 dollar. 6/14 While 9/14 many commodities 1/14 1/15 are /15 in oversupply, 6/15 9/15 oil is the most important to consider. U.S. oil supplies have continued to rise despite falling prices (FIGURE ). Energy companies 0.0 have adjusted to lower oil prices by cutting costs and improving production efficiencies, allowing a number of them to remain profitable. Because China s recent U.S Crude currency Oil devaluation Inventories renders and Oil commodities Prices more expensive there, demand could slow further, exacerbating, and extending low prices. Among the ECB, the BOJ, and -1.0the Fed, only the Fed has a dual mandate of full 110,900 employment Germany and stable inflation. U.S. The other central banks sole mandate Japan 100 is stable prices. UK Until commodity prices rise -1.5appreciably, there is little reason for central banks to,800 1/14 /14 6/14 9/14 1/14 1/15 /15 6/ /15 retreat from their accommodative stance ,700,600 4 FIGURE 70 U.S. Oil Inventories Have Risen Despite Falling Prices 60 U.S. Crude Oil Inventories and Oil Prices Oil Price ($/barrel) (RHS) 50,000,500 Inventories 1,900 (millions of barrels, LHS) 400 1/09 1/10 1/11 1/1 1/1 1/14 1/15 1,800 1,700 1, Year Real Yields (%) Oil Price ($/barrel) (RHS) 1,500 Inventories (millions of barrels, LHS) 1,400 1/09 1/10 1/11 1/1 1/1 1/14 1/15 Note: Oil price is West Texas Intermediate crude. Sources: U.S. Energy Information Administration, Bloomberg Populations in the Developed World Are Aging Across developed markets, people are getting older. According to the United Nations, the percentage of people over age 65 in developed markets is projected to rise to 5% by 040 (FIGURE 4). This demographic shift has enormous economic and financial implications. Aging investors tend to prefer bonds as a way to reduce risk and earn regular income. Because investors in developed markets own the vast majority of the world s financial capital, an aging population suggests strong ongoing demand for bonds. As older people leave the work force, they also tend to consume less. Most of global consumption, a critical component of growth, occurs in developed markets, so the aging population implies lower potential growth worldwide. Wellington Management s U.S. economist estimates that the shrinking U.S. work force could lead to an estimated.75% drop in potential growth there alone. FIGURE 4 Developed Fig 4 Markets Are Older and Aging Faster Than Emerging Markets 0% 5% 0% 15% Fig 4 10% Percentage of Population Ages 65 And Above 0% 5% 5% 0% 0% Source: 15% United Nations 10% Percentage of Population Ages 65 And Above 000 Developed Markets World Emerging Markets Potential Risks to This View What 5% could derail these arguments and send yields substantially higher? The case for much higher yields, in my 0% view, rests largely on a turnaround in the slow-growth EM picture, specifically China. Just as investors de-rate markets for slower-than-expected EM growth, they could also re-rate faster-than-expected growth by driving yields higher Developed Markets World 004 Emerging Markets

4 Investment Implications Maintain exposure to high-quality government bonds. With limited risk of substantially higher yields, investors should be more comfortable with this exposure. These bonds can also play a unique role in portfolios in an equity sell-off. Avoid replacing core fixed income with riskier credit. Many investors have abandoned core fixed income and piled into riskier credit strategies because of fears of higher interest rates. Risks to equity markets abound, but higher interest rates aren t one of them. Pundits may be blaming the equity market turmoil on both China s slowdown and higher interest rates, but I think fears of higher rates are overblown. I expect developed market equities to bounce back once the markets rate fears subside. The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. 4

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8 At Hartford Funds, your investment satisfaction is our measure of success. That s why we use an approach we call human-centric investing that considers not only how the economy and stock market impact your investments, but also how societal influences, generational differences, and your stage of life shape you as an investor. Instead of cookie-cutter recommendations and generic goals, we think you deserve personalized advice from a financial advisor who understands your financial situation and can build a financial plan tailored to your needs. Delivering strong performance is always our top priority. But the numbers on the page are only half the story. The true test is whether or not an investment is performing to your expectations. Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling (retail) or (institutional). Investors should read them carefully before they invest. All investments are subject to risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Foreign investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Commodity investments are subject to additional risks. The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. Hartford Funds are underwritten and distributed by Hartford Funds Distributors, LLC. Hartford Funds Management Company, LLC is the Funds investment manager and the Funds are subadvised by Wellington Management Company llp. Wellington Management Company llp is a SEC-registered investment adviser and is unaffiliated with Hartford Funds. All information and representations herein are as of 9/15, unless otherwise noted MFGS_0915 hartfordfunds.com hartfordfunds.com/linkedin