The Envestnet Edge, September 2014

When it Comes to Interest Rates, Who Says What Comes Down Must Go Up?

We are, at long last, nearing the end of one of the great central banking experiments: the U.S. Federal Reserve’s policy of quantitative easing, which began in the wake of the financial crisis of 2008-2009. While the unwinding of the monthly purchases of billions of dollars of mortgage-backed securities and other bonds has been going on for many months, markets are now increasingly attuned to what comes next. And the primary question is quite simple: will interest rates rise and if so, by how much and when?

The conventional wisdom appears to be simple as well: of course rates will rise. The Fed will begin to raise short-term rates some time in 2015 from the current level of zero, and that (is what we believe) will trigger a rise in longer-term rates, for U.S. Treasuries as well as for corporate and sovereign bonds around the world. Some analysts and investors are sanguine about those prospects; others are considerably more alarmed, and warn of tumult and turmoil ahead as bonds markets are jolted out of their multi-year complacency. Two recent headlines read: "Fed could jolt markets," and "Fed exit may be a bumpy ride." A bill was even introduced in Congress (again) to curb the powers of a Federal Reserve which, according to select pockets of opinion, has usurped powers and is damaging America’s economic future.

It is impossible to know what the effects will be, given that we are in uncharted macroeconomic and policy waters. But we should, at the least, challenge the assumption that the end of very easy money will mean the end of all easy money or the beginning of significantly higher rates.

The long-term trends

Understandably, most of us focus on immediate trends and the near future. The zero interest rate environment combined with the Fed’s policy of quantitative easing are indeed a product of the post 2008-2009 financial crisis.

However, the overall climate of low interest rates well predates the past five years. That is true not just for the United States but for the world as a whole.

It's been frequently said over the past few years that interest rates are being kept "artificially low" by central banks. But that view is critically undermined by the pattern of rates over the past thirty years. Take a look at U.S. Treasuries since the early 1980s. In September of 1981, rates peaked at 15.84% due in part to the aggressive policies of then Fed Chairman Paul Volcker to curb inflation. It has been a steady downward trend since then. Yes, the financial crisis led to a low rate regime, but then again, so did the aftermath of 9/11 and other crisis points along the way. Overall, rates over the thirty years from September 1981 went from nearly 16% to a low of just above 1.6% in September 2012.

And while it is certainly true that rates have crept up close to 3%, the long-term trend is still dramatically down. While the proportional increase from 1.6% to today's 2.6% is significant, in absolute terms it is minimal.

This is not simply a U.S. trend. Rates have been tumbling globally as well. In the early 1990s, just as the European Union was congealing, rates on German bonds hovered around 9%. Those have since declined precipitously and are now hovering at around 1%. Throughout the European Union, in fact, rates have descended to lows not seen the Napoleonic Wars of the early 19th century1. Yields on sovereign debt around the world have likewise declined, and not just in Japan, whose struggle with zero interest rates and minimal growth has been laboriously discussed. Countries once seen as risky and carrying high rates, ranging from Turkey to Peru, have also witnessed falling yields.

Corporate debt yield has also declined, with investment grade bonds yielding in the range of 6% at the beginning of the millennium and falling to around 3.5% now. The only real outliers in these trends are… the outliers: countries such as default-prone Argentina, whose access to international credit markets is de minimis at best, and Greece at the height of the Euro debt crisis in 2011.

Most of us are aware that we are in a low-yield environment (it would be hard not to be). But the sheer power of these multi-decade moves lower undermines the equally strong convictions that the current environment is a product of central bank policies in the wake of 2008-2009.

If not central banks, then what?

This thirty-year period has been a golden period for bonds. For sure, part of that period coincided with a strong bull market in equities, especially in the United States from the early 1980s until March of 2000. But since then, equities have been both volatile and flat, while bonds have continued their relentless bull-march, with yields falling and prices rising.

Investor behavior has naturally followed. Faced with wrenching declines in equities between 2000-2002 and again from 2008-2009, money poured into bonds, especially U.S. Treasuries. The only year where bonds saw relatively less flows was 2013, a very strong equity year. But 2014 has seen a return to the multi-year trend of bond flows well-outpacing U.S. equities. The only slight twist this year has been a new preference for international equity, even with the outperformance of U.S. stocks.

It may be, of course, that global yields have stayed low largely because of aggressive moves by central banks. Even with the Fed coming to an end of quantitative easing, the European Central Bank is beginning to ramp up its own. And it may be that yields are low because growth is anemic and will stay that way, though as Envestnet's Chief Investment Strategist Tim Clift recently discussed in MarketWatch, such fears are also likely overblown given the slew of positive economic data in the United States.

But if the role of central banks is being exaggerated, then we are missing other causes. The past thirty years has seen a dual revolution in information technologies and the emergence of a massive and increasingly robust middle class. The net effects of both are lower global labor costs, less expensive goods and services, and more than a billion new participants in the global capital system. Those technologies and new consumers have created much more seamless flows of trade and capital, with the attendant systemic risks (as we saw in 2008-2009), but also the benefits of greater liquidity and cheaper capital around the world.

If that is true, then lower rates are a manifestation of greater stability and global growth, even if that growth is more evident outside the developed world.

What now?

Clearly, rates do not have much lower to go. And there has been modest movement upward, at least for U.S. Treasuries. But if this long period of declining rates is approaching an end, it does not necessarily mean an inevitable period of rising rates lies ahead. Indeed, we could be in for a protracted period of relatively static low rates, with periods of volatility and uncertainty of course, but with that static trend still in place. That would mean neither great pain nor great gain for most bond investments.

If technological innovation and the emergence of the global middle class continue, companies exposed to those phenomena will continue to reap disproportionate rewards, as they have been for well over a decade. That, in turn, would explain the strange yet undeniable strength in equities—at least as credibly as the thesis that equity markets are up and bond yields are down only because of central bank machinations.

So, in short, by all means prepare for the end of the bond bull market. It is probably done. By all means consider the possibility of a bear market in bonds and turmoil in equities. It would seem that most of us are doing just that. But we should also be prepared not for the trend to reverse but rather for it simply to stop, with stocks a beneficiary, as they most certainly have been, with or without the help of central banks.

Advisor Take-Away:
Now close to the end of the Fed’s quantitative easing—and perhaps the bond bull market as well—many of us expect the end of a historically low-rate environment. However, low rates are not simply a product of the 2008-2009 financial crisis. The multi-decade trend—both in the U.S. and globally—has been lower and lower rates, along with muted inflation. Furthermore, factors other than central bank policy could influence interest rate movements and may continue to increasingly do so, namely: information technology, and the robust growth of the middle class across international markets. Knowing all this, investors may need to prepare for a possible static rate environment, and consider opportunities—global equities, in particular—that benefit from innovations in technology and robust global consumer activity.


Articles By This Author

The Envestnet Edge, May/June 2018 Video: Five (Investing) Rules To Live By The Envestnet Edge, March/April 2018 Video: Buy The Dips Video: No Place Like Home? Market Bias Perceptions and Realities The Envestnet Edge, February 2018 The Envestnet Edge, January 2018 Video: Raging or Aging: How Much Longer Will the Bull Last? Webinar Replay: 2018 Market Outlook The Envestnet Edge, December 2017 Video: Bitcoin, Bubbles, and the Bigger Picture The Envestnet Edge, November 2017 Video: Taxes are certain, but don't obsess about tax reform The Envestnet Edge, October 2017 Video: Time to stock up on growth or value? The Envestnet Edge, September 2017 Video: Time To Take A (Measured) Risk? The Envestnet Edge, July/August 2017 Video: Bitcoin: Buy Or Buyer Beware? The Envestnet Edge, June 2017 Video: FANG, FAAMG: Too Big a Bite of the Market? The Envestnet Edge, May 2017 Video: Invest "As If" The Envestnet Edge, April 2017 Video: What To Do In Quiet Markets The Envestnet Edge, March 2017 Video: Bull Or Bear: Should Investors Still Care? PMC Weekly Review - March 10, 2017 The Envestnet Edge, February 2017 Video: Separating markets from politics, is it really a "Trump rally"? The Envestnet Edge, January 2017 Video: Investing in Trump’s Economy? Proceed With Caution The Envestnet Edge, December 2016 Video: Have We Only Just Begun? The Envestnet Edge, November 2016 Video: Rotations, Reversals, Rising Rates: A Time to Reposition Post-Election, Will Markets and Portfolios Emerge Winners or Losers? Webinar Replay: Post-Election Winners and Losers The Envestnet Edge, October 2016 Video: In a 2-2-2 world, look for modest economic growth and expansion PMC Weekly Review - September 16, 2016 The Envestnet Edge, September 2016 Video: Diversification is working in 2016 (so far) The Envestnet Edge, July/August 2016 Video: Valuations: it's all relative Brexit: Plunging into the Unknown? The Envestnet Edge, June 2016 Video: Equity valuations and bond yields: reach no further PMC Weekly Review - June 17, 2016 The Envestnet Edge, May 2016 Video: Hitting singles: a measured approach for this investing season The Envestnet Edge, April 2016 Video: Investing with impact: increasingly a matter-of-fact Video: In this election cycle, will investors be winners or losers? The Envestnet Edge, March 2016 PMC Weekly Review - March 11, 2016 Video: In a low-growth world, less could be more The Envestnet Edge, February 2016 The Envestnet Edge, January 2016 Video: Markets are a mess, but don't jump to conclusions yet A Most Challenging Year Video: Interest Rates and Energy: The Highs and Lows of Year-End The Envestnet Edge, December 2015 The Envestnet Edge, November 2015 Video: We'll always have Paris The Envestnet Edge, October 2015 Video: Politics and the markets: déjà vu all over again? Video: China, Commodities, and Crisis: What's Next for Emerging Markets? The Envestnet Edge, September 2015 PMC Weekly Review - September 11, 2015 Is This The Big One (Financially Speaking)? Probably Not. The Envestnet Edge, August 2015 Video: In a "meh" market, look again at U.S. stocks The Envestnet Edge, July 2015 Video: Is this the Big One? What to do in a financial crisis Don't Worry About China Don’t Believe the Hype About Greece The Greek Catastrophe Is Finally Here (Unless It Isn’t) The Envestnet Edge, May/June 2015 Video: When Following the Herd is Risky, Where is the Safety? The Envestnet Edge, April 2015 Video: The End of Short-Termism is Long Overdue PMC Weekly Review - April 24, 2015 The Envestnet Edge, March 2015 Video: Keep Your Friends Close and Your Robo-Advisor Closer The Envestnet Edge, February 2015 Video: The Return of the Comeback: Is 2015 the Year for International Stocks? PMC Weekly Review - February 13, 2015 Why the Jobs Report Means Diddly Don’t Turn America Into Europe PMC Weekly Review - January 23, 2015 Video: Active and Passive: The Yin and Yang of Investing The Envestnet Edge, January 2015 Will Politics in 2015 Catch Up with the Economy? Video: Our Perspective on 2015: Maintain Yours The Envestnet Edge, December 2014 PMC Market Commentary: December 12, 2014 No, This Is NOT the '90s Economy Again PMC Market Commentary: November 14, 2014 Video: 2014 U.S. Midterms: A Win for Stocks? The Envestnet Edge, November 2014 Whose Economy Will It Be in 2016? PMC Market Commentary: October 17, 2014 Video: Special Video Commentary: Market Volatility and Fundamentals The Envestnet Edge, October 2014 Don’t Panic! Video: You Know What’s Not Sustainable? Ignoring the Opportunity in Impact Investing PMC Market Commentary: October 10, 2014 Greenberg’s Folly Naomi Klein Is Wrong PMC Market Commentary: September 26, 2014 Subprime Loans Are Back! Video: When it Comes to Interest Rates, Who Says What Comes Down Must Go Up? The Envestnet Edge, September 2014 PMC Market Commentary: September 12, 2014 Why Indie Bookstores Are on the Rise Again The Fed Is Not As Powerful As We Think PMC Market Commentary: August 22, 2014 Americans' Sour Mood on the Economy Doesn't Square with the Fact The Envestnet Edge, August 2014 Video: The World is in Crisis... the Markets are not PMC Market Commentary: August 8, 2014 PMC Market Commentary: July 25, 2014 Punitive Damages Video: Market Valuations and The Theory of Relativity The Envestnet Edge, July 2014 Don’t Kill the Export-Import Bank. Clone It. How India’s Economic Rise Could Bolster America’s Economy Video: Separating Risk from Reality PMC Market Commentary: June 27, 2014 No Sex Please, We're French PMC Market Commentary: June 13, 2014 The Envestnet Edge, June 2014 PMC Weekly Market Review, May 23, 2014 The Envestnet Edge, May 2014 Don't Bet on Rising Wages PMC Market Commentary: May 9, 2014 The Sharing Economy: Why Are So Many So Afraid? PMC Market Commentary: April 25, 2014 The Obsession with CEO Pay Won't Help the Middle Class PMC Market Commentary: April 11, 2014 Time to Face Reality: Our Unemployment Problems Are Structural PMC Market Commentary: March 28, 2014 In Defense of Relentless Optimism The "Made in China" Fallacy Forget GDP - Use Big Data