Lower for Longer

Today we saw the 10-year yield hit its lowest rate since November.  While some of the pressure is related to the tensions with North Korea, if markets were really fearful the worst would become reality, we’d see a full “risk on” trade, with equities taking a big and sustained hit, but we aren’t seeing that on the equity side.  Rather, these tensions are merely adding to already existing factors weighing on interest rates.

The inability for rates to sustain a move higher is no surprise to us, as we have written for years about the long-term drags we see on global rates, specifically the aging population and the long-term demand implications.  Here are some excerpts from our writing, “Pricing Risk and Playing Defense,” from early this year:

We believe that the biggest surprise awaiting investors in 2017 involves bond yields and interest rates…With Trump’s election, it is now “consensus” that the Federal Reserve is going to raise rates another three times in 2017. I question this assumption.  In fact, we may have already seen the highs on the 10-year Treasury in mid-December 2016 as it breached 2.6%.  Global growth has not changed since Trump was elected. The Euro Zone remains a complete mess and Brexit is not going to help.

Demographics and a massively levered global economy continue to be the dominant themes. The world is aging and this has enormous economic ramifications, including a shrinking labor force in the richest, most developed countries, swelling pension burdens, and slowing consumption. According to Pew Research, “Growth from 1950 to 2010 was rapid—the global population nearly tripled, and the U.S. population doubled. However, population growth from 2010 to 2050 is projected to be significantly slower and is expected to tilt strongly to the oldest age groups, both globally and in the U.S.”1

Again, we expect these demographic trends to have a continued and lasting impact on economic growth and final demand, and in turn, with lower demand we expect constrained interest rates.

Over the past nearly five years we have seen periods of spikes in 5-yr and 10-yr Treasury rates, only to see them fall again.  For instance, the 10-year Treasury surpassed 3% in 2013 on the “Taper Tantrum” as the Fed reduced the amount it put into the economy (QE).  But that was quickly followed by longer term rates returning to a downward path through 2014 and into 2015.  We saw rates move up some in the second half of 2015 as we prepared for the first Fed Funds rate hike in eight years, only to fall again after that December 2015 rate hike.  Rates spiked following the Presidential election, and surpassed 2.6% level on the 10-year, as the Fed also made a December 2016 and March 2017 rate hike, but again fell back even while the Fed continued with a June 2017 rate hike.  In 2017, as we had expected, we have seen a tightening of the yield curve, as the 2-yr rate moves up on rate hikes but the longer-term 5-year and 10-year don’t follow suit.

What the last five years have shown is that despite four Fed rate increases and all of the “tapering” and ending of QE that has been done along the way, the 10-year today sits at the same level it was in May 2013, and we have seen it revisit this level numerous times over this period.

Many have seemed to abandon their expectation for a September Fed Funds rate increase, with many now even doubting we’ll see the Fed move in December, as inflation remains persistently below the 2% target level.   The Fed is expected to start reducing their balance sheet in the coming months, but the expectation is that they will make it a priority of reducing large mortgage holdings before Treasury holdings, and anything done will be gradual, thus we don’t anticipate significant pressure on Treasury rates.

Just as we have stated for the last several years, we don’t expect to see a sustained and significant move higher in interest rates.  Aging demographics will continue to weigh on global demand and consumption. We are also seeing societal and behavioral shifts on the younger generation, with the shared economy and consumption trends across a variety of areas impacted. The political situation domestically remains a mess, with political infighting putting the expected tax cuts and infrastructure spending that promised growth in question, or if it is able to get through Congress, will likely be muted. Thus, we don’t see that as a big drive of GDP growth.

As we look at just what this means for us in the high yield market, we expect the low rate environment to continue.  So despite the fact that we have seen compression in yields within the high yield space over the last year and a half, relative to other fixed income options we still believe high yield bonds and loans remain an attractive option for investors that are looking for tangible income generation and yield.  While we are seeing yields (yield-to-worst) of around 6% for the various high yield bond indexes, we believe an active and thoughtful portfolio of high yield bonds has the ability to produce yields higher than that of the market indexes, as well as the potential for some capital appreciation.

1  From the piece, “Pricing Risk and Playing Defense,” http://www.peritusasset.com/wp-content/uploads/2017/03/Pricing-Risk-Peritus-Letter-Final.pdf.  “Global Population Estimates by Age, 1950-2050.” Pew Research Center, Washington, D.C. (January 30, 2014). http://www.pewglobal.org/2014/01/30/global-population/.
2 Data from 1/1/13 to 8/28/17 sourced from the Federal Reserve and Department of Treasury websites, https://www.federalreserve.gov/monetarypolicy/openmarket.htm and https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2013.
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