The Long and the Short of It: Making Sense of the Current Interest Rate Environment

With the extent and speed of the move in sovereign bond yields, is interest rate exposure less attractive for investors? Not necessarily.

So far this year, the U.S. equity market has both set new record highs and experienced more than a –6% return in a single month. Even while garnering headlines, stock market performance may not be the most notable part of 2019. Bond yields have fallen dramatically this year: After peaking at 3.24% in early November 2018, the U.S. 10-year yield has fallen more than 100 basis points (bps). In fact, May’s 38 bps decline was the largest in a single month since early 2015.

The figure is a line graph of the S&P 500, superimposed with that of the 10-year U.S. yield, over roughly the last two years. Over the time period, the S&P made a modest gain of about 2%, while rates dropped to about 1.95%, down from 5%. The two variables move in downward directions from September 2018 through late December 2018, after which the S&P started its upward trajectory, as rates on the 10-year continue to fall. The chart shows the S&P taking a less step trajectory in the second quarter of 2019, while rates continue downward with the same slope.

Softening global growth, uncertainty stemming from U.S.–China tensions — and perhaps a recognition of the real and likely protracted nature of the conflict — as well as dovish pivots from the U.S. Federal Reserve and other central banks have all contributed to the move lower in sovereign yields globally. In fact, markets have become increasingly confident in Fed rate cuts, pushing interest rates to the lower end of many observers’ expected ranges.

So, where can interest rates go from here? First, a long-term perspective may be helpful.

The long view

We still see a New Normal/New Neutral world marked by lower growth (particularly given aging demographics in many regions of the world), persistently low inflation, and a likelihood of lower interest rates. We affirmed this view at our Secular Forum in May, in which we developed our outlook for the next three to five years.

Lower trend growth underpins our expectation for range-bound rates – so while rates can drift up from here, we don’t expect dramatically higher yields to prevail. This is also in line with our long-established New Neutral range for neutral policy rates of 2%–3% (the midpoint of which now corresponds to the Fed’s expectation as well).

What’s more, our secular baseline outlook foresees a recession – not imminent, but likely over the next three to five years. As central banks have made exceedingly clear, policy rates should go to zero quickly in such a scenario and stay there for an extended period of time. The capital appreciation potential from interest rate exposure — particularly given the little room for shock absorption that low and decelerating growth implies — is a key consideration for investors today.

So interest rate exposure — or duration — may be warranted in the longer term. But what about today?

The short view

Interest rates in the low 2’s may seem unattractive if we’re not headed for an imminent recession, but there are reasons why maintaining interest rate exposure could be prudent. For one, a Fed biased toward preemptive rate cuts could put policy rates as low as 1.25%–1.5% ­if market expectations are correct, which would mean that the levels today for the 10-year yield may be appropriate. Second, given slowing global growth and deceleration ahead for the U.S. expansion (in part as stimulus effects wear off), there remains little distance from zero or negative growth rates. The downside risks to the economy — whether from more tariff action, trade wars, growth shocks, or declining confidence — may loom large.

With more downside risks, interest rate exposure may be the best way for investors to hedge credit or equity risk in portfolios. Not only does the U.S. have the highest yields globally from which to benefit while gaining diversifying exposure, but it also has the most room for rates to fall in the wake of a downside risk materializing. In fact, a recessionary shock — with policy rates heading to zero — could result in new lows for the U.S. 10-year and provide the capital appreciation that may be a much-needed ballast for investors in a more challenging market for risk assets. 

For more on rates and central banks, please see “Off-Target: Central Banks and the Mystique of 2%.


The Author

Scott A. Mather

CIO U.S. Core Strategies

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Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.