LISA BLACK, HEAD OF GLOBAL PUBLIC FIXED-INCOME MARKETS
JOSEPH HIGGINS, MANAGING DIRECTOR, PORTFOLIO MANAGER, GLOBAL PUBLIC FIXED INCOME
October 21, 2013
Interest rates and market volatility increased beginning in May after the Federal Reserve announced it would “taper,” or scale back some of its $85 billion in monthly bond purchases in September. The announcement caused disruption and modest losses for many fixed-income investors, but signaled the beginning of a gradual Fed exit from its third quantitative easing (QE3) program and the central bank’s historically low interest-rate policies. Investors were surprised, then, in September when the Fed backed off plans to taper, citing concerns over higher mortgage rates and continued fiscal retrenchment in Washington.
Our view is that while the “taper caper” surprised investors, the Fed’s decision to gradually reduce its monthly asset purchases has been delayed by three-to-six months. Tapering may occur as early as December, although failure by Congress to settle the debt ceiling and the government shutdown in a timely manner could push the start of tapering back to March 2014. We see ending QE3 as a gradual process that will likely begin in the near future and continue to build through 2014. As the Fed begins to scale back QE3 and policies designed to keep rates low, a more “normal” interest-rate environment will begin to emerge, one in which rates are increasingly influenced by economic and market forces and less by extraordinary central bank policy measures.
Preparing for higher rates
While the Fed has delayed a decision on tapering, some effects of higher rates have already been experienced as investors prepare for more movement. One example is the 10-year Treasury yield, which recently moved higher than the equity dividend yield of the S&P 500. The 10-year yield had dropped below equity dividend yields at the height of quantitative easing, contrary to their historical relationship, signaling an unsustainable imbalance between bond and stock prices. The chart here shows this relationship from 1990 to the end of September.
While tapering also likely means higher interest rates than we have now, they are not likely to rise as high as they had been before the financial crisis. In our view, the possibility of the fed funds rate1 (now at 0.12%) returning to 8%, 6%, or even 4% are remote.
We anticipate that a sustainable absolute yield for the 10-year Treasury will be in the 3.5%-4.5% range. That includes expected inflation of 2% or so and a real interest rate of approximately 2%. Our outlook for interest rates is based mostly on expectations that the country’s economy will generally grow more slowly than it has in the past, due in part to an aging population and secular decline in the labor participation rate.
Deciphering the Fed
When considering the future direction of rates, it’s important to bear in mind that the Fed remains committed to keeping the fed funds rate near zero through mid-2015. In fact, a reading of recent Federal Open Market Committee minutes suggests the committee is still more concerned with deflation than inflation. It is also alert to the downside risks of tapering too quickly, which could push up interest rates too fast and hurt the recovery, particularly for mortgage rates, a critical component of the nascent economic recovery. The Fed noted that inflation is still running well below its 2%-2.5% target, and the labor market, while improving, is still unsteady. Also, consumers continue to reduce their debt, which is deflationary. Janet Yellen, recently nominated to replace Ben Bernanke as the Fed chairman, would likely keep the Fed’s focus on job creation, which may result in a slightly more dovish Fed if she is eventually confirmed, as expected.
In short, we believe the Fed will wait to begin tapering until there are enough signs that growth is sustainable. Monthly payroll gains of 200,000 on a consistent basis would likely qualify, as would a sustained increase of industrial output, improvement in consumer and business spending and a clearer path for fiscal policy. Improvements in a few of these areas could induce the Fed to begin tapering. At this point, there is a good chance that the Fed will begin some degree of tapering by March.
Potential risks to the current outlook: Washington and inflation
Today, the major risks to a mostly benign economic and interest-rate outlook are domestic. Washington recently engaged in another budget and debt ceiling fight which resulted in a short-term solution for both. The major risk would be a policy misstep between now and early next year that fails to achieve a longer-term solution for the debt ceiling or federal government spending.
Another risk to a benign interest-rate scenario would be an unexpected rise in inflation that forces up interest rates faster than expected. In the current environment, this risk seems extremely remote. Part of the reason is that there’s still a significant amount of excess labor capacity in the U.S. and excess production capacity globally. Labor does not currently have pricing power, and a strengthening dollar, thanks to interest rates that are higher than last spring, puts a lid on price increases for imported goods.
Inching along the path to higher rates
The yield on the 10-year Treasury, an important bellwether for the larger bond market, is now 2.7%, or nearly double the low of 1.38% set on July 24th, 2012. While we expect the 10-year to rise further, to a 3.5%-4.5% range by late 2014, the fixed-income market will likely adjust to the increase more readily than we witnessed recently, with less spread volatility. In fact, spreads on many fixed-income products may well decline, helping to offset some portion of the overall expected increase in rates. The reason for this is that these increases are now a base expectation for much of the bond market: they will not come as a surprise, at this point. Quantitative easing, part of the extraordinary measures the Fed has taken to keep long-term rates low and bolster economic growth, will eventually taper and conclude.
In summary, we know that the bond market will continue to face pressure from rising rates in the near future. However, investors should consider their fixed-income investments contextually, incorporating the fact that a significant price correction has already occurred, and that other types of assets may or may not have a similar degree of volatility going forward. An investor’s time horizon remains an important consideration as to how much fixed-income should be held in relation to equities and other investment categories. Longer investment horizons can benefit from what may be further outperformance of equities versus fixed income, but nearer-term time horizons may find bonds remain the more suitable choice. A bond market driven increasingly by fundamentals and Fed forward guidance rather than QE specifically should take root in the months and years ahead.
1 The Federal Funds rate is the overnight interest rate that large depository institutions lend to each other.
The information provided herein is as of October 21, 2013.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.
Please note that fixed income investing involve risk.