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Charting the Market: What to make of the Great Interest Rate Debate?
Matthew Bartolini takes a look at a few charts to help frame a view on the path of rates as we get deeper into a wild and weird 2020.
Over $7 trillion of US Treasury debt has a yield below 1%, adding to the $43 trillion of global total debt that trades below a 1% yield.1 Low policy rates, low growth, low relative inflation, and investors playing defense amid heightened macro risk from the Global COVID-19 Crisis (“the GCC”) have all played a part in this new low/no-rate era in the US and across the world.
With a looming US presidential election, ongoing Fed purchases of Treasuries amid heightened Treasury supply to fund the fiscal stimulus plans – not to mention a potential second Congressional stimulus plan – along with the hopes of an economic recovery as communities continue to reopen, the outlook for interest rates is quite uncertain. This is even though implied interest rate volatility has been in the bottom 1 percentile over the past three years, as we show in our cross-asset volatility monitor in this month’s Chart Pack.
In this charting the market, we will take a look at a few charts to help frame a view on the path of rates as we get deeper into a wild and weird 2020.
Two trends differ In this month’s Chart Pack, we depict current and historical trends of the US 10-year yield’s relationship to two macroeconomic activity barometers: the ISM US Manufacturing PMI and the copper-to-gold ratio. The two metrics are different, as one could think of PMI as a lagging indicator, given that the activity was already registered, while copper-to-gold is a leading metric, given that it’s derived from investor pricing expectations. It may also include some aspects of global trends, given the usage of the metals on a global scale.
Historically, the US 10-year yield has trended in the same direction as the ISM US Manufacturing PMI, considering that the latter illustrates economic activity and the US 10 year ultimately reflects future growth and inflation expectations. As a result of the impacts from the GCC, the initial reactions of both of these variables were similar. However, with some communities and companies reopening, the ISM has bounced back. Yet, the US 10-year yield has remained constrained, as shown below.
Source: Bloomberg Finance L.P. as of 07/31/2020. Past performance is a not a guarantee of future results.
Contrary to the above trend, after a brief decoupling, the copper-to-gold ratio has started to revert to be back in line with the US 10-year yield. Similar to the insights gleaned from PMI, the copper-to-gold ratio can provide information about the outlook for the economy, as copper is more of an industrial metal that should reflect an uptick in economic activity, while the yellow metal is more of a safe-haven/preservation of wealth/defensive commodity. As a result, the ratio should follow a directional trend similar to that of the US 10-year yield. As shown below, since the deviation in early July, the copper-to-gold ratio has fallen.
Source: Bloomberg Finance L.P. as of 07/31/2020. Past performance is a not a guarantee of future results.
Breaking down the ratio, copper initially rallied based on reopening hopes, but lately, gold prices have surged in large part due to a weakening dollar and the fact that low real rates are likely increasing the relative attractiveness of gold – a trend we also show in the Chart Pack. Also, over the past few weeks, the stronger gold prices have coincided with increased concerns surrounding the potential impairment of US economic growth momentum from uneven community reopenings as a result of COVID-19 hot spots emerging. The ratio and 10-year rates are now moving in the same direction as a result, and since the rate of change is higher for the ratio than the US 10-year yield, the gap between the two is narrowing.
The GCC has upended behaviors and changed trends’ lines across a multitude of markets, and perhaps, old indicators are no longer useful. However, PMI levels do indicate that yields should be higher. Yet, the copper-to-gold ratio offers support for these low levels. This disagreement is reflective of the uncertain converging forces at play.
Converging forces at play The Federal Reserve has extended their balance sheet significantly to increase liquidity and offer support to the capital markets, creating an imbedded constant buyer of Treasuries (roughly $80 billion a month) – as well as other debt instruments . Conversely, at the same time, the sizable fiscal stimulus has and will continue to increase supply – nominal coupon issuance will climb $132 billion over the next quarter. 2 There is also a looming election that could have an impact on the rates market. However, it is unlikely to roil it like it did back in the 2016 election – when interest volatility increased by 55% and the US 10-year rose almost 100 basis points – as GCC-related uncertainties plus an extremely dovish Fed are likely to temper any wild swings upwards.
But that’s not to say that the election won’t have an impact, as three-month implied interest rate swaption volatility is above that of one- and six-month implied swaption volatility, as the three-month expiry covers the time period of the election.3 And there is a scenario in which the election could be contested or results delayed due to the increased usage of mail-in voting, where the victor is not known until well after November 3. If that scenario does come to fruition, safe havens are likely to be sought, and that could pressure yields lower around that event. In November of 2000, when the Florida recount occurred for the Bush-Gore election, US 10-year yields fell 60 basis points through December 13, 2000 4 while all the hanging chads were being sifted through.
Regardless of the outcome, both administrations are likely to increase spending to combat the pandemic, and this will most certainly increase Treasury supply, impacting the yield curve by pushing longer-term rates higher, as stimulus should be inflationary. The supply, the stimulus, and the potential for political schadenfreude are all likely to impact the path and pace of the rates market ahead. But the risks are likely asymmetrical, leaving few reasons to buy.
Reasons to buy? From a pure portfolio construction perspective, there are three fundamental reasons to buy Treasuries.
Total Return from falling rates and the duration-induced price appreciation
For reason number one, Treasuries provide little income now, considering that the entire yield curve is under 1.3% and 30-year yields are 58 basis points lower than those of large-cap stocks.5 This is one of the reasons why we have seen ETF investors shed government bonds ($4 billion of outflows in July) in favor of IG and high yield corporates ($12 billion of inflows in July) as of late.
For number two, of course, the defense still exists, as Treasuries have the backing of the full faith and credit of the US – even if Fitch portends the outlook to be negative.6 However, the price of the defense is not what it used to be, as Treasuries’ yield per unit of duration is at its lowest point ever, at 0.05 7 – meaning that the risk-return profile is asymmetrical and there is more downside risk than upside, as the income produced may not be sufficient to cover any duration-induced price declines.
Given this structural deficiency from a risk-return perspective, this has led investors to seek out other potential portfolio risk mitigation solutions, such as gold – as evidenced by seven consecutive months of over $1 billion of inflows into gold-related ETFs, which have raised the 2020 total flow figure to north of $30 billion.
For number three, traditional paradigms have been upended, so historical comparisons to forecast mean reversion are not as reliable as they usually are. However, our preferred historical measure is the current yield difference to an exponential 36-month moving average, which reveals that current yield levels are 67% below that metric – the largest discount ever. This indicates that mean reversion is more likely than a continued move lower, and Fed Chair Powell has been dismissive of the idea of negative rates as well.8
Defensive income alternatives Looking ahead, expect rate volatility to kick up as the above converging forces play out and election ramifications grow closer. Yet we must consider that the plan is to recover, and a health solution plus stimulus are what is going to get us there. As a result, rates are likely to be higher in the future, with the yield curve modestly steepening; but make no mistake — as a result of dovish policy, rates will still be low relative to history. Therefore, for those looking to play defense and get income, the asymmetrical risk-return pattern of Treasuries may not be attractive.
In lieu of Treasuries, a mix of gold and high-quality intermediate corporates could provide a packaged return stream that is lowly correlated with equities – based on historical trends9 – but with a weighted yield that is 40 basis points10 higher than that of intermediate Treasuries, to potentially satisfy a portion of a portfolio’s income needs as well.
Continue following SPDR® Blog to keep up with my Charting the Market series and other market insights. You can also download our full monthly Chart Pack .
1 Based on the holdings of the Bloomberg Barclays Global Aggregate Bond Index as of 08/05/2020 per Bloomberg Finance L.P. 2 “U.S. Borrowing Breaks Fresh Records, Shifting Focus to the Fed”, Bloomberg 8/5/2020 3 “U.S. Presidential Election Bulldozes Its Way Into Rates Market”, Bloomberg 08/05/2020 4 This was the day Al Gore conceded the election 5 Based on the S&P 500 Index dividend yield as of 08/05/2020. 6 “United State Outlook to Negative by Fitch” Bloomberg, 08/01/2020 7 Bloomberg Barclays US Treasury Index yield to worst is 0.40 and the duration is 7.39, leading to yield per unit of duration of 0.05 per Bloomberg Finance L.P. as of 08/05/2020 8 “Fed chair Powell: The US won’t have negative interest rates”, CBSNews 5/18/2020 9 Spot price of gold correlation to the S&P 500 Index from 06/30/1990 to 06/30/2020 has been -0.01, per Bloomberg Finance L.P. as of 06/30/2020 and the Bloomberg Barclays US Intermediate Corporate Bond Index correlation to the S&P 500 Index to the S&P 500 from 06/30/1989 to 06/30/2020 has been 0.30, per Bloomberg Finance L.P. as of 06/30/2020. The correlation between gold and the Bloomberg Barclays US Intermediate Corporate Bond Index from 06/30/1989 to 06/30/2020 is 0.25, indicating a potential low correlation to equities when blended together. 10 Bloomberg Barclays US Intermediate Corporate Bond Index yield to worst is 1.26%, and at a 50% weight, the blend would be 0.63%, which is 40 basis points more than the Bloomberg Barclays US Intermediate Treasury Index, which has a yield of 0.20% as of 08/05/2020 per Bloomberg Finance L.P.
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