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Low Yields in Historical Context: Breaking the Narrative of Rising Rates
Ever since the Global Financial Crisis, US and European investors have been acclimating to persistently lower yields in fixed income portfolios (Japan already has substantial experience in this regard). As we write this blog, the 10-year US Treasury yield is closing in on the “historical” lows witnessed in 2012 (1.39%) and 2016 (1.36%). On the horizon, there has consistently been a market view that once we work through this period of abnormally low rates, we will return to a higher, more “normal” level of rates. We believe it is time to break this narrative and move past the thought that yields are destined to return to those normal levels in the near future. In doing so, it is necessary to re-visit the history of interest rates to provide a longer-term perspective. The primary implications of such a study are as follows:
Interest rates are not mean-reverting: There has never been a normal historical level for rates that exerts a gravitational force
As low as they are currently, some yields (e.g., US corporate bond yields) are not at their historical lows
While rates may rise, there is also justification to believe that they could persist at the current levels (or lower) for decades
For the purpose of this blog, we will focus on major economies that were historical financial centers of the world, as it is difficult to obtain a full data set of world interest rates.
Today’s Interest Rates Within a 500-year Context
Over the past 500 years, the world’s financial hub moved from the Mediterranean (the “Genova Cycle”) to the Netherlands, then to the United Kingdom, and in the early twentieth century, to the United States. This evolution reflects a globalization of commerce and of financial markets. With each of these transitions, one can observe a degree of disruption in the level of rates and markets readjusting to new supply and demand dynamics. In this 500-year context, the exception appears to be the unprecedented spike in yields during the “US Cycle”. Following the emergence of the gold standard (Bretton Woods, 1944), where global currencies were pegged to the US dollar and gold, there was a steady rise in global 10-year government rates that extended past the collapse of the system in 1971, leading to a peak in 1981. History has demonstrated that peaks in rates associated with disruptions are followed by long periods of low interest rates. A return to such an environment would not be unprecedented.
Corporate Yields from the 1930s to 1950s
As a recent (relatively speaking) case in point as to how yields could persist at low levels even in the absence of a prolonged recession, we could look at corporate bond yields over the past 100 years. As evident in Figure 2, US corporate BBB-rated bond yields persisted below our current low for 20 years from 1936 to 1956.
Were there different factors at play back then? Yes, absolutely. While we may have some of the same factors driving down yields currently, we likely have new factors as well (e.g., US$16 trillion of negative yielding bonds in the Bloomberg Barclays Global Aggregate and counting). Similar factors at play include a global economy emerging from a recession following a period of rapid growth, stagnation and low volatility.
Our Views on the Current Environment
Our fixed income team believes that the move downward in rates through most of 2019 has been a result of the market’s gradual recognition that the world has transitioned to an extended period of structurally lower growth (but not necessarily recession), lower inflation and lower rates. This low inflation environment in turn is allowing central banks to employ extraordinary monetary measures. However, the move in the past month – a rapid, fiercer decline in yields – appears to be different. We believe that in accordance with rising volatility in equity markets, this latter period is more a result of short-term cyclical and technical factors than long-term structural ones.
It is important to segment these two distinct periods and describe what it means for investors. First, most of the downward movements in rates in 2019 may not necessarily signal expectations of a recession, but perhaps a period of slower (but positive) growth. Second, observing the rapid decline in rates may lead one to believe that we could reach much lower yield levels should a real downturn come to fruition.
Putting today’s environment in a historical context suggests that a return to higher levels of rates is not a given; there is no mean-reverting pull at play. Investors sharing this view may want to consider the following investment options:
US Investors: Consider maintaining the current portfolio duration levels or extending even further. This is especially true for rate-sensitive investors such as insurance companies and pension funds. Corporate defined benefit plans, in particular, should consider continued de-risking. Look beyond traditional long-duration benchmarks for a more capital-efficient approach. A barbell approach may also extract value with the yield curve inverting at the short end.
European Investors: Our advice for gilt (UK government bond) investors is similar to that for the US ones: Pension funds should extend duration (potentially using leverage) and de-risk where possible in a capital-efficient way.
Outside of the UK, the belly of many major euro-area government rate curves exhibits negative yields. Again, allocations to longer-duration portfolios could limit the impact of negative yields. Another option could be to increase yield (and risk) by moving out of sovereigns and into credit, and where possible, moving into international debt while hedging currency risk.
Japanese Investors: At this time, investors should be careful not to seek too much income or capital gains by increasing duration, credit or liquidity risk. Instead, they should moderate or minimize these risks and seek to capture carry and roll-down from steeper external yield curves while hedging currency exposure back to the JPY.
The views expressed in this material are the views of Hiroshi Yokotani through the period ended 08/26/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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