Sep 21, 2017

Will Low Bond Yields Ever Increase?

By Gene Balas

Low interest rates may be frustrating to investors but a godsend to homebuyers and other borrowers. But what factors have kept bond yields so low for so long, and when might yields increase? Central bank actions, demographics, and low inflation are three of many factors influencing the level and direction of bond yields, as we discuss in our recent publication on the subject in greater detail.

  • Inflation may increase towards (or possibly even exceed) the Fed’s 2% target, particularly if the economy “runs hot” while unemployment is low by historical standards
  • Central banks are becoming less accommodative, which may allow bond yields to rise
  • But large numbers of retiring workers may continue to demand fixed income securities

Although forecasting interest rates can be fraught with error, the non-partisan Congressional Budget Office prepares estimates of interest rates, including that for the 10-year Treasury note. These estimates are used for preparing the federal government’s budget, including interest expense on the federal debt. Let’s consider each of these three variables we outlined above, and then we’ll get to the CBO’s forecasts for interest rates over coming years to put these variables together in a quantified format.

Inflation

Inflation has been quite low of late, with the Fed’s preferred measure of inflation, the rate tied to personal consumption expenditures (as published by the Bureau of Economic Analysis), falling consistently short of the Fed’s 2% target over the past number of years.

There seems to be a stalemate, where absent significant wage increases, workers cannot afford to pay much in higher prices. At the same time, companies have little pricing power, so they are reluctant to give their workers significant wage increases. This is especially true given low productivity gains, which are the missing ingredient that would allow profits and wages to rise at the same time. However, companies having difficulty finding workers with the skills they need amid low unemployment may potentially break this logjam.

As such, the Federal Reserve does forecast that inflation over the long run will be about 2%, and if this estimate is eventually baked into consumers’ and businesses’ expectations, there is a good chance that inflation may indeed hover around 2% in the future. After all, inflation expectations are one of the biggest drivers of the actual inflation rate.

Central bank actions

This brings us to the next aspect of why yields are so low; namely, actions by central banks, not just the Fed but also the European Central Bank (ECB). These institutions both bought massive amounts of bonds, and in a global market, a shrinking supply of high grade bonds generally means higher prices (and lower yields).

Now, the Fed will soon begin shrinking its balance sheet, allowing maturing bonds to roll off the portfolio instead of the Fed reinvesting those proceeds in more Treasuries. Since the expansion of the Fed’s balance sheet coincided with falling interest rates; reflexively, perhaps we might suspect that the opposite action of the Fed would be consistent with a rising rate environment.

The role of demographics

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As the population ages and Baby Boomers entire retirement, they may approach investing differently when they are depleting their portfolios instead of building their retirement accounts. As people retire, they may reallocate their portfolios to a more conservative asset allocation, one favoring more fixed income than equities to generate income and possibly reduce risk. This demand for fixed income securities may pull down yields (and bond prices up). Indeed, going back over thirty years, real rates (after subtracting inflation) had fallen as the proportion of the population over retirement age had risen.

Putting it all together

So, you may ask, what does the CBO forecast for bonds yields in coming years? The CBO believes that the 10-year Treasury yield will increase over coming years to reach 3.6% in 2023, and then the CBO assumes rates will stay around this level. Of course, when any organization publishes data such as these, it comes with the caveat that actual results will differ. And the CBO’s methodology would generally indicate a range of potential outcomes, not just the single point forecast that they publish in the federal government’s annual budget, which is the source of these forecasts.

As a result, having walked through this exercise of putting many pieces of this puzzle together, it may be logical to believe the CBO’s forecasts have merit. It’s possible that interest rates could indeed increase, should conditions in coming years dictate.

What should investors do?

  • If interest rates rise, then bond prices fall. However, if you need a lump sum at a particular point in time, maturing bonds near that date may give you the funds that you need – regardless of what happens to interest rates in the meantime.
  • A laddered bond approach, where maturing bonds are reinvested at the long end of the ladder, may allow a portfolio to “climb” the ladder if rates should rise, even though prices will fluctuate until the bond in question matures.
  • Remember that interest rates are hard to forecast consistently and accurately, so one may want to consider other information, such as your own personal circumstances and objectives for your portfolio, before embarking on any campaign to remake your portfolio.
  • Of course, your United Capital financial adviser is the best person to help you in your financial life planning needs, so reach out to him or her for guidance.

Conclusion

Finally, remember that any number of factors could delay, derail or speed up this trajectory. Some factors may mean a later timetable; others, an earlier one. But perhaps most importantly, our final caveat is simply to view any interest rate forecast as a wide range of potential outcomes instead of just a single number at the center, even if the thesis makes conceptual sense. That means that investors should be prepared for many possible environments – and to consider risks such as rising interest rates along with myriad other variables.

Disclosure: Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. The opinions expressed in this article are those of the author and not necessarily United Capital Financial Advisers, LLC. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. In general, the bond market is volatile, and fixed income securities carry interest rate, market, inflation, credit and default risk. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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