At the beginning of 2014, the 10-year U.S. Treasury was yielding 3% and few forecasters projected that the widely-held benchmark would be hovering around 2.5% in late September. What is this unexpected rally telling us?
The decline in yield is consistent with a global theme of lower rates, but it is inconsistent with the fundamentals of a strengthening U.S. economy. This raises the question of whether interest rates in the U.S. will remain "range-bound." As rates rise and fall in cycles, bond markets move with them, impacting portfolio performance across fixed income sectors.
Going Separate Ways
Discrepancy in monetary policy between the Federal Reserve and other developed market central banks, especially the European Central Bank (ECB), explains some of the downward pressure on U.S. rates this year.
While the Fed has been ratcheting back its monetary easing, announcing an October end to its asset purchases and signaling that it will raise the fed funds rate in the coming year, the ECB is moving in the opposite direction. It has recently unveiled several extraordinary new measures to counter the threat of deflation and lower financing costs across Europe. These include a negative deposit rate, asset-backed security purchases and, potentially, the purchase of European sovereign bonds.
The Bank of Japan (BoJ) is also expected to continue its monetary stimulus.
The Fed's actions should incentivise U.S. rates to increase, while ECB policies should lead to a decline in European rates. As interest rates in Europe continue to grind lower on the back of ECB action, some investors believe this could restrain the upward march of rising rates in the U.S.
Interest rates should theoretically move based on macroeconomic fundamentals. In the U.S., growth is picking up (in the second quarter, GDP expanded at an annual pace of 4.6%) and this improving growth picture will soon require a higher short-term interest rate. If inflation expectations rise as well, then 10-year U.S. Treasury yields should begin to increase from their current very low levels.
Implication for investment
The next rising rate cycle will be historic, whenever it begins, marking the end of a 30-plus year bull market in fixed income. Investors will need to think differently about their allocations to this asset class.
Recently interest rate volatility has been muted, but that could quickly change. Amid escalating tensions in the Middle East and hardly a sign of resolution in the Ukraine-Russia conflict, it seems likely that markets could experience some bouts of volatility in the quarters ahead.
Fixed income has long served as a bulwark in a multi-asset class portfolio. In times of volatility, that role is particularly important. And especially in a rising rate environment, investors should be certain to diversify their fixed income portfolios by both strategies and sectors. We don't know precisely when the next rising rate cycle will begin, but we do know that a balanced, well-diversified portfolio should be well-armed to make the turn.
