So far this year, the U.S. equity market has both set new record highs and experienced more than a –6% return in a single month. Even while garnering headlines, stock market performance may not be the most notable part of 2019. Bond yields have fallen dramatically this year: After peaking at 3.24% in early November 2018, the U.S. 10-year yield has fallen more than 100 basis points (bps). In fact, May’s 38 bps decline was the largest in a single month since early 2015.
Softening global growth, uncertainty stemming from U.S.–China tensions — and perhaps a recognition of the real and likely protracted nature of the conflict — as well as dovish pivots from the U.S. Federal Reserve and other central banks have all contributed to the move lower in sovereign yields globally. In fact, markets have become increasingly confident in Fed rate cuts, pushing interest rates to the lower end of many observers’ expected ranges.
So, where can interest rates go from here? First, a long-term perspective may be helpful.
The long view
We still see a New Normal/New Neutral world marked by lower growth (particularly given aging demographics in many regions of the world), persistently low inflation, and a likelihood of lower interest rates. We affirmed this view at our Secular Forum in May, in which we developed our outlook for the next three to five years.
Lower trend growth underpins our expectation for range-bound rates – so while rates can drift up from here, we don’t expect dramatically higher yields to prevail. This is also in line with our long-established New Neutral range for neutral policy rates of 2%–3% (the midpoint of which now corresponds to the Fed’s expectation as well).
What’s more, our secular baseline outlook foresees a recession – not imminent, but likely over the next three to five years. As central banks have made exceedingly clear, policy rates should go to zero quickly in such a scenario and stay there for an extended period of time. The capital appreciation potential from interest rate exposure — particularly given the little room for shock absorption that low and decelerating growth implies — is a key consideration for investors today.
So interest rate exposure — or duration — may be warranted in the longer term. But what about today?
The short view
Interest rates in the low 2’s may seem unattractive if we’re not headed for an imminent recession, but there are reasons why maintaining interest rate exposure could be prudent. For one, a Fed biased toward preemptive rate cuts could put policy rates as low as 1.25%–1.5% if market expectations are correct, which would mean that the levels today for the 10-year yield may be appropriate. Second, given slowing global growth and deceleration ahead for the U.S. expansion (in part as stimulus effects wear off), there remains little distance from zero or negative growth rates. The downside risks to the economy — whether from more tariff action, trade wars, growth shocks, or declining confidence — may loom large.
With more downside risks, interest rate exposure may be the best way for investors to hedge credit or equity risk in portfolios. Not only does the U.S. have the highest yields globally from which to benefit while gaining diversifying exposure, but it also has the most room for rates to fall in the wake of a downside risk materializing. In fact, a recessionary shock — with policy rates heading to zero — could result in new lows for the U.S. 10-year and provide the capital appreciation that may be a much-needed ballast for investors in a more challenging market for risk assets.
For more on rates and central banks, please see “Off-Target: Central Banks and the Mystique of 2%.”