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Is lower for longer over?

Bryan Borzykowski  |  12 Feb 2018Text size  Decrease  Increase  |  
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With the stock market continuing to gyrate wildly, it's easy to forget that, until now, equities had generally moved in a straight line higher.

Since the market hit its trough, the S&P 500 has climbed more than 280 per cent as of this writing.

In January alone, it was up more than 5 per cent. One big reason why stocks have done so well up until this point is that bond rates have been at historically low levels. The 10-year US Treasury yield hit its lowest point ever, 1.36 per cent, not even two years ago. It's hard for investors to make any money at those interest-rate levels, so, naturally, they turned to stocks.

Now, though, the idea that we're still in a "lower for longer" rate environment is being questioned by many financial professionals. With the 10-year Treasury yield rising by about 18.75 per cent year-to-date--it was at 2.85 per cent at the time of writing--ultralow rates are now a thing of the past. But where do rates go from here? Do they get to levels where investors move money from stocks to bonds?

Rates rising

Bob Michele, global head of fixed income for JPMorgan Chase, says that the "lower for longer" story is changing. The tools that helped pushed down rates, such as quantitative easing and short-term rate cuts, have done their job, he says. We're now in a rising rate environment, not just in the U.S., but, after this year, in Europe and Japan as well.

"Everything is being thrown into reverse," he says, adding that in January 2017, central banks around the world were spending US$167 billion on bond purchases; they spent only $44 billion this January.

With those monetary policy tools now being withdrawn, it's only natural that yields would rise to more normal levels. However, it's unclear as to what "more normal levels" means. Michele thinks rates are "absurdly low" given the strong economic recovery we've seen, but until quantitative easing disappears entirely, he doesn't think the 10-year Treasury yield can rise much above 3.25 per cent.

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Where does he think rates should be? Somewhere around 5.25 per cent. Historically, he says, the real rate on the Fed funds rate has been about 2.25 per cent. If the Federal Reserve is targeting 2 per cent inflation, then that would put the overnight rate at about 4.25 per cent and the 10-year Treasury yield at around the 5 per cent mark. The Fed fund rate is currently about 1.25 per cent, so it's still got a long way to go, but with at least three rate hikes priced into the market today, and the talk of a potential fourth hike, we could see an overnight rate of at least 2 per cent by year end.

"It might seem as though we're far away from that now, but if you look at the long-term charts, that (4.25 per cent and 5.25 per cent) is actually in the lower part of where the Fed funds and Treasury has traded over the last 100 years," he says.

A slow climb higher

Other fixed-income fund managers, though, aren't as bullish on rising bond yields. Steve Bartolini, who's a member of T. Rowe Price's fixed-income team in the US, doesn't think 10-year Treasury bond yields will rise much further from here. While stock investors may be just waking up the fact that bond yields have climbed, the increases have been occurring over the last four months, he notes. In fact, the 10-year Treasury yield is up about 40 per cent from September, when it was hovering around 2 per cent.

He thinks today's rates are more in line with where they should be, given where we are in the economic cycle.

"I'm not concerned we're going to see five-year notes, which backed up by 100 basis points over the last four months, rise another 100 basis points over the next four months," he says.

Although he doesn't think rates will decline from here, Bartolini would still characterise the current environment as a low-rate regime. Unlike some equity investors, he doesn't think inflation will hit 3 per cent--technology, globalisation, labour dynamics and demographics will keep prices low for a while, he says--and that should keep bond rates across the curve somewhere between 2.75 per cent and 3 per cent. That doesn't mean markets won't experience volatility--inflation and bond yields could spike higher on occasion--but he doesn't see rates pushing much beyond the 3 per cent level over the longer-term.

Gemma Wright-Casparius, a portfolio manager for Vanguard in the US, shares Bartolini's view that rates will stay around where they are today. Vanguard's fair value model has the 10-year note between 2.75 per cent and 2.8 per cent for the year.

"I don't think rates will be anything more than fair value given the fundamental backdrop," she says. "We don't see inflation as a major threat to the economy going forward. Demographics, globalisation and the advent of technology is depressing productivity, so as far as we can tell, there's no significant upside risk to inflation."

Of course, it's hard to predict where markets might go, and there are some risks to these forecasts. Wage growth--which jumped by a surprising 2.9 per cent year-over-year in January and was, according to many, a catalyst for the equity sell-off--could grow even more rapidly, and that could cause capital goods and import prices to rise higher, says Wright-Casparius.

However, she doesn't see that happening. Core inflation, which is growing at less than 1 per cent, would need to rise substantially for bond prices to see a more meaningful increase. All that said, Wright-Casparius does think we're still in a lower rate for longer environment, with rates still at multidecade lows.

Continued bumpiness ahead?

In theory, a low rate environment is good for stocks, hence the last few years of equity gains, but clearly, there is some concern among stock-pickers that the risk-free rate between bonds and equities is tightening. If investors feel that they can make money owning a lower risk security, like a bond, then, of course, they'll choose to own that asset over a riskier one. 

Bartolini doesn't think we're at the point where people will start moving wholeheartedly into bonds. The accommodation phase is ending, he says, but we're not yet in a tightening phase where rates rise so high that equity investors panic--but we may not see the same kinds of gains we’ve seen in years past.

"We're starting to figure out where the break-even point might be between yield curves and equity markets, but we're in the early innings," he says. "We expect it to play out over many months going forward, assuming the economic data holds together."

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Bryan Borzykowski is a freelance columnist for Morningstar.com. 

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