A New Normal? Time To Recheck Interest Rate Assumptions

Among the remarkable characteristics of today’s global fixed-income marketplace is the $15 trillion invested in negatively yielding bonds.

During a recent series of interviews with U.S. investment experts focused mainly on the topic of equity market volatility, another topic frequently mentioned was the machinations of the global bond markets.

Bob Browne, chief investment officer, Northern Trust, summarized the matter: “I continue to be surprised by my fellow asset management professionals who think that the long-term norm for the 10-year U.S. Treasury should be closer to 4% or even 4.5%,” Browne says. “This is just too high when you consider among other facts that there is $15 trillion invested the bond markets globally right now that is carrying a negative interest rate.”

Browne and others explain this as one of the lingering legacies of the Great Recession. “On the day of this discussion the Swiss 10-year is at negative 90 basis points, the German 10-year is trading at negative 56 basis points, and the Japanese 10-year is at minus 20 basis points,” Browne says. “So, why would the U.S. 10-year trading at close to 1.5% or 1.75% seem low? It’s in fact unusually high in the global context.”

Steve Foresti, CIO at Wilshire Consulting, offers a similar take: “I don’t think we can expect to get back to the levels of the 1970s or 1980s in this new global world. I agree that if you compare where U.S. yields are versus Europe, it really puts things into perspective. In Germany, France and other places you have negative yields right now. That means you’re paying to hold these ‘safe’ assets, not getting paid. So, seeing a U.S. rate down below 2% makes sense in that perspective. They are relatively high compared with other developed markets.”

Explaining the Lower Rate Environment

Browne suggests the unprecedented ability of technologically enabled manufacturers and service providers to deliver supply fast and nimbly to the global marketplace has done a lot to reshape the inflation outlook. Among other outcomes, Browne says, this supply-side dynamic has allowed interest rates to move much lower than was the assumption 15 or 20 years ago.

“From a simple macroeconomic perspective, people have underestimated how quickly supply can shift and adapt to meet changes in demand,” Browne says. “This helps keep rates low because there is not much if any supply-based price inflation in the globalized and Internet-informed economy. We will need to see a fundamental shift in the demand curve in order to see bond yields go much higher, either in the U.S. or globally.”

Browne further observes that, in recent years, when U.S. GDP growth was in the range of 3%, the markets barely pushed the 10-year Treasury rate to 2.25%. In his opinion, the U.S. Federal Reserve is underestimating the likely response of the bond market to sub-2% GDP growth.

“We believe we have peaked in this rate cycle and that the 10-year yield could eventually go down to 1%,” Browne says. “Again, thanks to macroeconomic forces that are here to stay, it appears that yields can remain dramatically lower versus what people would have thought possible just 10 years ago.”

What to Do About the New Normal

What are the investment experts doing with this information?

“We’re looking for interest rate exposure without simply owning bonds, and we’re having to compensate by utilizing more equity exposure,” Browne says. “We’re buying global infrastructure equities, global real estate investment trusts [REITs] and high-quality stocks with growing dividends. These are liquid strategies that should be helpful for the retirement market moving forward. You can’t be overly dependent on one source of income.”

Foresti says the recent bout of equity market volatility has shown some of the risks in this approach, but it is nonetheless necessary in the new normal.

“Any time you go through a bout of volatility like we are in now, it tests a few things,” he says. “First, it tests whether the portfolio you have in place is truly consistent with your tolerance for risk.  Times like these are a really good test of the connection between perception and reality around risk and return. We’ve come off some market highs after an extended bull market.”

Foresti encourages investors, both institutions and individuals, to take the emotion out of the picture when adjusting to the new normal. “Each bout of volatility always feels a bit like the first time, and to some extent there is truth to that. It is always something different that causes the sell-off and it’s always a new set of concerns and expectations about the future which one must deal with,” he explains.

Facing this picture, institutional investors have the advantage of following a well-articulated governance structure that makes it harder to deviate and let negative behavioral tendencies impact the portfolio. Individual savers, on the other hand, don’t necessarily have the checks-and-balances of a governance structure and stated long-term goals. It’s easier for the individual’s gut to take over.

“This is important to understand because the new normal for interest rates simply means that retirement investors have to take more risk,” Foresti concludes. “If I need to generate 7% returns and a low-risk fixed-income investment is not even going to give me 2%, this outlook starts to paint the picture of the additional risk you’ll need to take with your growth assets. It will mean more investment in equities or perhaps having to take illiquidity risk in private market investments. It’s a challenge that both institutions and individuals are going to have to deal with.”

Browne and Foresti conclude that it is as important today as ever to educate people about what volatility really means. Just because the dollar value of a portfolio went down for two or three days, if one didn’t sell anything, one didn’t suffer any harm in that respect.