June 17, 2013
by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
Fixed income investors have been struggling to find attractive yields over the past few years. With short-term Treasury yields near zero and long-term rates held down by the Federal Reserve’s (the Fed) QE program, many investors have moved into riskier sectors of the fixed income markets in search of more income. Now that the Fed is signaling a potential end to QE, it may be the beginning of higher Treasury yields, which could help investors who are looking for higher yields but hesitant about taking so much risk. But it’s not likely to be a straight or rapid rise in rates in our view. We think the road to higher rates will be a long and winding one, with a few distinct phases.
The first step on the road to higher interest rates would likely be paring back the Fed’s bond-buying policy. We think that this could happen later this year if job growth picks up. The Fed has indicated that a change in policy could come if there was a substantial improvement in the pace of job growth. One Fed governor has said that this means six consecutive months of job gains of 200,000 or more. The recent six-month average is 208,000, so if the current pace continues, then it may mean the Fed begins to exit its QE program later this year—perhaps announcing the shift at the September FOMC meeting.
Buying fewer bonds isn’t the same as actually tightening monetary policy. It’s a less easy policy. Nonetheless, we believe that just by signaling a shift in policy, longer-term interest rates could start to move higher. Meanwhile, short-term interest rates are likely to remain anchored near zero. As a consequence, the yield curve would steepen with long-term rates rising relative to short-term interest rates.
How high could rates go in the first phase? In the past, 10-year Treasury yields have averaged about 1.6% more than the fed funds rate. Currently, the yield difference is above the long-term average at about 2%. But the yield spread has expanded to as much as 4% at times when the Fed is in the process of raising short-term rates. Based on this history, we think that long-term interest rates have room to move up from current levels in phase one, but will not likely reach 4% or higher until the Fed is actually in a tightening mode.
10-year Treasury yield and effective federal funds rate: 1983-2013
Source: St. Louis Federal Reserve 10-Year Treasury Constant Maturity Rate (GS10), percent, quarterly, not seasonally adjusted and Effective Federal Funds Rate (FEDFUNDS), percent, quarterly, not seasonally adjusted. Data as of Q1 2013.
This first phase could take some time—possibly a year or longer. The Fed’s current policy involves buying $85 billion per month in Treasury and agency mortgage-backed securities. Tapering down the pace of purchases is likely to be a gradual process and, based on comments from Fed Chairman Bernanke, will depend on the economic and inflation data.
In the second phase, we would expect the Fed to raise short-term interest rates steadily over the course of one to two years. Stronger economic growth and higher inflation are likely to be prerequisites for this tightening.
Currently, the pace of economic growth and inflation are running below long-term averages. Nominal GDP—the growth rate before the effects of inflation—has been rising at a year-over-year pace of 3.9% since the first quarter of 2010 when the most recent recession ended. This is well below the 5.2% pace seen between 2001 (the previous recession) and the start of the financial crisis in 2008.
Nominal gross domestic product (GDP) and 10-year Treasury yield: 1983-2013
Note: Nominal GDP is the gross domestic product (GDP) figure that has not been adjusted for inflation.
Source: St. Louis Federal Reserve Gross Domestic Product, 1 decimal (GDP), percent change from year ago, quarterly, seasonally adjusted annual rate; 10-Year Treasury Constant Maturity Rate (GS10), percent, quarterly, not seasonally adjusted. Shaded bars represent recessions. Data as of Q1 2013.
Historically, there has been a relationship between year-over-year growth in nominal GDP and 10-year Treasury yields. Since 2000, excluding recession time periods, 10-year Treasury yields have averaged about 70 basis points less than nominal GDP growth. This relationship implies that 10-year Treasury yields could rise to the 3% to 3.5% region at the current growth rate. However, even stronger growth will probably be needed to push interest rates back toward higher levels.
Slow growth tends to keep inflation low because there is excess labor and capacity available. With excess labor, wage growth tends to be low—as it is now. Price increases are kept in check by soft demand for goods and services. Inflation has recently been trending lower and is below the Fed’s target of 2% by nearly every measure.
Consequently, we believe this second phase could take a while to develop. There could be a relatively long stretch between the end of tapering and the beginning of tightening. The majority of voting members on the FOMC project that the first increase in interest rates will occur in 2015. Once the Fed begins to raise interest rates, the pace of increase in short-term rates will depend on how quickly the economy is growing and inflation. Assuming a gradual increase in both, it could take a few years for the Fed to bring short-term interest rates up to its “longer run” target of 4%, which based on the Fed’s projections appears to be 2016 and beyond.
The third phase on the road to higher rates will most likely be when the Fed is actually selling bonds from its portfolio. Having purchased bonds to hold down long-term interest rates, selling bonds should cause long-term rates to rise. The Fed’s action would drain reserves from the banking system, reducing the amount of money available to finance economic growth. This final step would most likely send short and long-term interest rates to the cyclical peak levels.
However, it’s worth noting that the Fed does not have to sell the bonds it holds. They could be held to maturity, but we think the Fed would most likely reduce its holdings if the economy was growing fast enough to raise inflation concerns.
Projecting how high long-term interest rates will move so far into the future is difficult, if not impossible, and past tightening cycles don’t necessarily follow consistent patterns. We would only venture to estimate that if the Fed reaches its 4% fed funds target in 2016 or beyond, then based on past history, 10-year Treasury yields could move up to 5.0% or higher. But it’s worth noting that 10-year Treasury yields above 5% have been uncommon over the past decade. Only twice—in 2006 and 2007—have rates reached this level and even then, it was only for a short time.
10-year Treasury bond yields: 2003-2013
Source: St. Louis Federal Reserve. 10-Year Treasury Constant Maturity Rate (GS10), percent, monthly, not seasonally adjusted. Shaded areas indicate past recessions. Data as of June 3, 2013.
While it may be a long road to a 5% yield on 10-year Treasuries, a move up to 3.0% to 4.0% over the next few years as the economy recovers would not be out of line with historic valuations. Moreover, the bond market has demonstrated that it is sensitive to any hints of a shift in Fed policy. Even a gradual increase in rates can have a significant negative impact on the value of your bonds or bond funds.
We think it may make sense to limit your exposure to long-term bonds, consider using bond ladders, and look at adding high-quality investment grade corporate bonds and muni bonds.
A bond ladder, a portfolio of bonds with different maturity dates, allows an investor to earn interest income but have flexibility to reinvest proceeds of maturing bonds if rates increase. By spreading out maturities, the average duration can be in the intermediate range while still holding some longer-term bonds that generate more income.
However, bond ladders may underperform more targeted strategies. Bonds will still decline in price if rates rise and there will be an opportunity cost to waiting for bonds to mature to reinvest. Also, an investor may not be able to achieve as much diversification with a bond ladder as in a bond fund.
Another suggestion is to add some incremental yield and diversification with investment grade corporate bonds. In our view, the corporate sector appears to be in good shape with less debt relative to earnings than in the past and high levels of cash.
The risk is that investment grade corporate bonds tend to underperform Treasuries when the economy weakens and some individual bonds may be negatively affected by corporate events such as LBOs or mergers and acquisitions.
For municipal bond investors, we believe current valuations are reasonable. The average yield on investment grade muni bonds relative to Treasuries is 100% which means that on an after-tax basis, investors are getting more income than in comparable maturity Treasuries. We believe the current valuation reflects concerns about potential changes to the tax exemption for munis and defaults.
We believe investors need to be prepared for some rise in interest rates over the next few years. But we don’t advocate sitting on the sidelines waiting for a higher yields. Staying sidelined means missing out on the potential to earn income and reinvest that income over time. Furthermore, consensus forecasts have consistently overestimated interest rates over the past few years. We believe it makes sense to stay invested and develop strategies to manage the risk of rising rates.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security’s tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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