Don’t fight the wave of rising rates, surf it
Greg Wilensky, Head of U.S. Fixed Income, discusses the outlook for U.S. interest rates and the tools and investments available to navigate their rise.
- Rising yields does not mean investors should avoid core bond allocations. We expect the rise will remain orderly, and long-term inflation expectations will remain contained.
- Treasury exposure can be a key diversifier when equities markets are weak, while corporate bonds, securitized assets and floating-rate investments can add yield and diversification.
- An active manager should dynamically adjust exposures as conditions evolve while maintaining a core focus on finding the appropriate balance of risk and reward to meet investors’ goals.
U.S. bond yields have risen quickly in recent months and, given current expectations for an economic recovery, we expect they will rise further over time. Simply put, yields were too low given the improving economic outlook, and a normalization of interest rates should be expected. However, many factors will impact the speed of the rise, and their ultimate level, and we believe U.S. Treasury bonds continue to act as an important hedge to an investor’s overall portfolio, especially their equities. Bond investors, in our view, should focus on the benefits of duration (a measure of sensitivity to interest rate moves) as a hedge against unexpected volatility in the riskier parts of their portfolio, while aiming to outperform cash. The question for a bond investor today is not whether to have or avoid bond exposure, but how to find the right balance of bond exposures. While there is no guarantee that bonds will provide insurance against falling equity markets, we think the expected outcomes of a balanced portfolio are likely to be better for most investors.
Rates have risen before. What is different this time?
Since the mid-1990s, there have been five periods of rising interest rates, which we define as a period lasting at least 12 months. Interestingly, each period saw a progressively lower change in yields, with 10-year Treasury yields rising 2.24% in 1998-2000, and only 0.85% in 2017-18. The average rise was 1.47%. While one could argue that the approximately 1.0% rise we have seen since the lows of August last year would suggest the bulk of the rise may be completed, there are always mitigating factors. In the current case, the swift drop in yields as the pandemic took hold early last year skews the figures. Despite the recent rapid rise, 10-year bond yields are still below the 1.79% level at which they started 2020.1 But the most significant difference in the current cycle is that the U.S. Federal Reserve (Fed) is both tolerating government bond yields rising, while actively buying them in order to keep interest rates “low.” This apparent contradiction can be explained by the view that the Fed wants to see interest rates normalize, but in an orderly way.
On the Fed’s side is the relative value of U.S. Treasuries compared to the rest of the developed world. All else being equal, if you wanted to hold government bonds to guard against equity volatility, would you rather own 10-year U.S. Treasuries yielding 1.75%, or 10-year German Bunds at -0.3%? In fact, even after accounting for the cost to hedge the currency exposure, a German investor can realize an approximately 1.3% gain in yield by choosing U.S. Treasury bonds2. And it is not just foreign demand that may mitigate the speed of rising interest rates, but also domestic demand. Yield rises can be, in a sense, self-correcting insofar as the increasingly higher yields may attract buyers such as domestic pension funds.
Turning to more fundamental factors, the consensus forecast may be for a strong recovery; this can pressure yields higher because of the expectation that too much growth leads to inflation. Which, in turn, leads to the need for the Fed to raise official policy interest rates. But it is possible to have growth without a significant rise in inflation, and today’s conditions could prove to be a model of such a recovery. Unemployment is high. Savings rates are high. The “output gap” – the difference between what the economy can produce and is producing – is currently at -4% (Figure 1), suggestive of a reasonably high amount of slack in the economy. The U.S. economy may, relative to history, grow hotter for longer before reaching the same risk of rising inflation. Indeed, many of the same factors present today, including large fiscal deficits and significant Fed balance sheet expansion, have failed to get inflation to the Fed’s target over the last decade.
Figure 1: Positive output gaps need not trigger higher inflation
Source: Bloomberg, U.S. Real Output Gap as a % of GDP (CBO), U.S. Core Personal Consumption Expenditure year on year, NBER recession periods, quarterly, 31 December 1960 to 31 December 2020.
Nevertheless, there is risk of a surge in pent-up demand, and the recent $1.9 trillion Biden administration fiscal stimulus could see the output gap disappear entirely. Through excess demand, this could lead to the output gap turning positive to the tune of 2%, according to Deutsche Bank, the highest it has been since 2000. As demonstrated in Figure 1, history shows that a positive output gap in the region of 2% is unlikely to trigger a sustained break higher in inflation.
Were the fiscal multipliers (the ratio of change in national income that arises from a change in government spending) to be particularly strong, the economy could run very hot and exceed potential output by as much as 3% to 4%, which would place it in territory not seen since the mid-1960s and early 1970s – the beginning of a period known as the Great Inflation of 1965-1980 – and likely increasing the chances of a sustained inflation breakout.
Could history repeat itself?
The causes of inflation in the 1960s and 1970s are legion. Putting aside the oil price shocks of the 1970s, (the result of specific wars in the Middle East, which we hope are not to be repeated), the blame for rising prices lay primarily at the door of poor policy – both monetary and fiscal. It is perhaps the specter of this being repeated that unsettled rates markets so abruptly in February and March this year.
While there are perhaps parallels between Biden’s fiscal stimulus package and the inflated deficit spending to finance the Vietnam War or Nixon’s attempts to stimulate the economy ahead of his re-election in 1972, the output gap is considerably wider today and unemployment higher, offering a stronger justification for pump-priming. Moreover, the fiscal stimulus today will result in a fiscal cliff (assuming it is not repeated) in 2022 as the rate of change of government spending turns negative.
Turning to monetary policy, we think the Fed today is a far more experienced organization, not just because of the benefit of the passage of time and the lessons of hindsight but because the increased wealth of data available today allows it to make more informed decisions. While the move to flexible average inflation targeting creates some opacity around how much inflation the Fed will tolerate, we think it has a stronger grasp of inflation expectations.
For example, Treasury Inflation Protected Securities (TIPS) were only launched in 1997, so there was a less visible representation of market views on future inflation. Therein lay the problem: the Fed had a weaker grip on inflation expectations which allowed inflation to became entrenched. It would take a shift in public and political attitudes together with Fed Chair Volcker’s tightening medicine from 1979 before the U.S. would embark on the long disinflationary road.
Opening the floodgates
The uncharted territory this time round is the impact that pent-up demand will have on the economy. Household savings have risen, partly a cautionary response to uneconomic uncertainty, but also reflecting forced savings as households have been legally unable to spend on activities that they took for granted, from having a restaurant meal to travelling on holiday. Buoyant asset markets from housing to equities have also led to wealth accumulation. Yet Figures 2 and 3 reveal that most of the increase in savings and wealth has occurred among the upper income brackets. Checkable deposits among U.S. households may have risen by $2 trillion over the course of 2020, but only $92 billion of this rise was among the bottom 40% of households who have a higher propensity to consume than wealthier households.
Growth in savings and assets is skewed towards higher income groups
Figure 2: Change in U.S. checkable deposits, Q4 2019 to Q4 2020
Source: Federal Reserve Board, Distributional Financial Accounts Overview, income levels detail. checkable deposits, Q4 2019 to Q4 2020.
Figure 3: Change in U.S. total assets, Q4 2019 to Q4 2020
Source: Federal Reserve Board, Distributional Financial Accounts Overview, income levels detail. Total assets, Q4 2019 to Q4 2020.
A large part of the improvement in the balance sheet of lower income groups is the result of government transfer programs, which may not be repeated beyond this year. Regardless, we can expect a “sugar high” as the huge fiscal stimulus coincides with excitement around reopening, which will push up inflation in the short term, but this will likely fade.
We think the surge in consumption is unlikely to lead to a permanent shift higher in inflation without being accompanied by a meaningful expansion in household borrowing. Evidence here is mixed. Banks are in better shape than post the Global Financial Crisis (GFC) so the transmission mechanism of accommodative monetary policy ought to percolate through the banking system unhindered. Credit demand, however, seems to be the issue. As with the proverbial horse, it can be led to water but not forced to drink. There still seems to be resistance from households to take on additional borrowing. This is most acute in Europe, which seems to have followed Japan in moving towards a low-growth, low-yield environment, but even in the U.S., households have been more conservative with their borrowing since the GFC.
A potent question is whether the COVID crisis (and its disruptive long-term impact on the economy) has nudged the U.S. onto the same path as Japan and Europe. In which case, while yields may rise in 2021, their upper bound may be considerably lower than average.
Bond yields may be low, but so are cash yields
Rising yields do detract from performance, but you are also earning something during the time you hold the bond, providing a cushion against losses from rising rates. The bigger the yield spread a bond has over cash, the more “carry” (the incremental yield benefit from holding, or carrying, the bond instead of cash) you get. And, everything else being equal, when the yield curve is steep – as it is now – bonds should benefit from seeing yields “roll down” the curve. As the security’s time to maturity shortens, bond yields tend to fall in order to match the lower yields of the shorter bonds. Both the carry and roll down provide some cushion, permitting bonds to outperform cash even if yields rise, and the size of this cushion has substantially increased as the curve has steepened.
Figure 4 shows the history of the amount 5- and 10-year Treasury yields can rise (in basis points) over the next six months while still outperforming cash over the period. In both maturities, the levels have increased substantially in the last year, reaching levels not seen in four years. Thanks to low cash rates and a steep yield curve, the cushion provided for sitting on U.S. Treasuries has gotten bigger.
Figure 4: Rise in interest rates required for the holding to perform the same as cash over 6 months
Source: JPMorgan, Janus Henderson, as of 25 March 2021.
The importance of being earnest about diversity
Every investor has different goals, different time horizons, and different risk tolerances. For investors that want a balanced portfolio that will perform (that is, generate a reasonable risk-adjusted return) across different environments, “core” allocations to bonds have generally delivered. Even as interest declined towards – and in some cases through – zero, core bond benchmarks like the Bloomberg Barclays U.S. Aggregate Bond Index proved they could still rally when equities sold off. We don’t believe the current environment is so fundamentally different that this history should be ignored. Equity markets are (as of this writing) at all-time highs, and the risks of unknown or unexpected events are as prevalent as ever.
In the meantime, the Fed has a specific goal for inflation of 2.0% over time and with 10-year bond yields near 1.75%, real yields (the yield paid after taking into account expected inflation) are negative. This can make holding equities look relatively attractive. But we believe most investors would not be comfortable with the volatility – the risk – of a 100% equity portfolio.
When Treasury rates are expected to rise, it makes sense to have less exposure to them. But however strongly this view may be held, Treasury exposure can be a key diversifier when equities markets are weak. Additionally, fixed-rate corporate bonds and securitized assets, which typically provide higher yields/returns but a little less insurance against weak equity markets, add diversification. TIPS, and floating rate investments like many commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs), can provide even more diverse profiles of interest rate risk, income and defense. All of them provide some spread over Treasuries and thus provide an additional yield cushion which can help shield capital against rising interest rates.
An active manager can use all of these instruments to dynamically adjust exposures as conditions evolve, while maintaining throughout a core focus on finding the appropriate balance of risk and reward to meet investors’ goals. However inevitable it may seem that bond yields will rise, we believe bond portfolios have a core role to play in investors’ diversified portfolios, and the challenge is on the manager to surf the wave, not fight it.
1 Source: St. Louis Federal Reserve
2 Bloomberg as of 22 March 2021, Janus Henderson