Though historically low, U.S. interest rates are actually high in comparison to the rest of the developed world. U.S. bonds appear overpriced on domestic fundamentals, but they are a bargain based on global valuations.
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We believe the Fed intends to start the process of raising rates at mid-year. The change in the landscape that may cause the Fed to delay this process is a potential decline in core inflation.
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It’s our opinion that in the current environment a meaningful negative duration stance is not warranted even with overvaluation of the government bond market, as there may be better areas to potentially add value.
This document reflects the opinions, views and analysis of Western Asset regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal.
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A value investor is charged with being very explicit in analyzing risk. What are the specific expectations for a security, sector, or strategy, and how does that differ from the market price? The bigger the difference, the larger the potential margin of safety. With macro strategies, valuation will depend on factors subject to forecast error. What are the expectations, how do they differ from what is reflected in the market price, and what are the risk factors that will erode the margin of safety? The greater the uncertainty in the forecast, the lower the confidence in the margin of safety.
Future uncertainty can be a subjective, elusive concept. When is there not uncertainty? If the future is unknowable, why is uncertainty any higher now than at any other time? And yet I find myself looking at the interest rate landscape with some incredulity, thinking that uncertainty has never been higher. Most of us who have been immersed in the U.S. markets for several decades look at today’s interest rates as incomprehensibly low. But when we look at other developed countries around the world, we see 10-year maturity bond yields that in many countries are fractions of 1%. The major European periphery countries of Spain and Italy, deemed on the verge of collapse a little over three years ago, now enjoy yields substantially less than those in the U.S.1 And for a real head spinner, see Switzerland’s negative interest rate.
Negative 10-year interest rates? I have to pay to lend you money for 10 years! My confession is that despite a long time spent as a practitioner in the bond world, I really don’t understand negative interest rates. I actually used to believe that zero was a floor for interest rates. I’m sure my grandchildren will one day ask me how I failed to comprehend that zero was pretty much a ceiling for interest rates. If negative interest rates jumpstart the economy, policymakers must soon comprehend that more negative rates will be even better. And yet if you take your money and stuff it in a mattress, doesn’t that provide a better return?
This brings us back to today’s interest rate conundrum. Rather than being low, U.S. interest rates are actually high in comparison to the rest of the developed world. Developed market participants who sell their bonds to buy U.S. securities pick up a meaningful yield advantage, and since the dollar has been appreciating, they get a currency boost as well. U.S. bonds appear overpriced on domestic fundamentals, but they are a bargain based on global valuations.
Market participants often talk across each other when it comes to discussions of interest rates. Which interest rates are we discussing? Is it the central bank policy rate, in this case the overnight rate targeted by the Federal Reserve (Fed)? Or are we talking about long-term yields? Our practice is to approach this issue from two perspectives. The first is to evaluate the economic fundamentals and the probable path of Fed policy. The second is to focus on the fundamentals underlying the path of long-term inflation. The two are inextricably intertwined, and the analyses overlap, yet we still find some merit in looking at these issues separately.
Our view is that growth in the U.S. will be solid but unspectacular. Our working premise of 2.5% growth is not as optimistic as the Fed’s 3% forecast, but this is not a huge difference. Either rate would be sufficient for the Fed to follow through on its intention to raise the federal funds rate above zero. We believe the Fed intends to start this process at mid-year, consistent with the guidance it has been communicating.
The change in the landscape that may cause the Fed to delay this process is a potential decline in core inflation. As my colleague John Bellows noted in his recent white paper, “Fed Outlook for 2015,” Fed officials have stated that they need to be “reasonably confident” that they can attain their inflation target. The Fed has said it would look through the decline in headline inflation due to the drop in oil prices, which has always been its preference. But if, as we anticipate, core inflation is declining at mid-year, the Fed’s confidence in its forecast of ongoing 3% growth would have to be very strong before it would pursue policy tightening at that time.
The potential for error in GDP forecasting, particularly multiple quarters in the future, is very high. Actual GDP growth has consistently underperformed the Fed’s forecast over the last four years, and inflation has also remained below the Fed’s forecasts. On both counts, we are doubtful that the Fed will have sufficient confidence to tighten should core inflation meaningfully underperform its forecasts this year. Market prices also reflect expectations that the first rate rise will come later in the year. We have long felt the process would be a protracted one. When we specifically compare our view with today’s market prices, we find there is an insufficient difference to take a position.
Another perspective is the trend of long-term inflation. Over long periods of time, the story of long-term interest rates is just the story of long-term inflation. The factors governing long-term inflation are not always coincident with those governing short-term growth rates.
An example (admittedly contrived) to illustrate this point would be the 1982-1989 U.S. experience. This was a period of exceptional growth, indeed one of the great economic booms in history. Based on a prescription that higher-than-expected growth often leads to a Fed reaction function more inclined to raise rates, a bond investor who was forewarned that growth would be exceptionally high would have been inclined to favor short positions. However, as we all know now, the winning strategy then was to stay long: ignore the strong growth, lock in 14% on Treasury bonds and never sell.
You would have looked like a veritable idiot during the tightening cycles, and you would have been heralded during recessionary easing bouts, but on average, across the business cycle, staying long the 30-year bond was the best strategy. The basis for that strategy would have been the secular trend of declining inflation. The end of the Cold War, globalization, the technology revolution, and demographics all helped contribute, but the determination of the monetary authorities to achieve lower rates of inflation was crucial.
As we look at the inflation horizon today, we see conflicting elements. The long-term trend in global inflation is still down, surprisingly revitalized late last year by the plunge in oil prices. The disinflationary forces previously mentioned still exert their influence. The buildup of debt in the developed economies is a powerful headwind to economic growth prospects. But the key difference is the goal and determination of the monetary authorities. As devoted to lowering inflation to their 2% goal as central bankers were, their devotion pales in comparison to that behind the policy experimentation utilized in their attempts to increase inflation to at least 2%.
Our steadfast view has been that the downward trend in U.S. and global inflation would ultimately be arrested. Eventually, central bankers would get inflation back to their target, but this process would be a slow one, demanding a substantial continuation of monetary accommodation. Even we have been surprised by the renewed downshift in inflation. It clearly suggests this process will take even more time and that long-term rates will stay lower for longer…
…which brings us back to the interest rate conundrum, but from another perspective. Our views of lower-than-expected growth, declining core inflation, and a more dovish-than-previously-expected Fed would normally be pretty bullish for government bonds. However, these views look to be already fully reflected in yields on short- and intermediate-maturity government securities. Similarly, at the long end, our view of an extended period of below 2% inflation would normally be constructive for long bonds, except that this view also looks to be fully reflected in Treasury bond yields under 2.5%. Market pricing appears to have overshot optimistic scenarios across the yield curve.
Where does this leave us? We believe there is no long-term value in current Treasury prices, but we respect the crosscurrents that underpin current yield levels. As such, it’s our opinion that in the current environment a meaningful negative duration stance is not warranted even with overvaluation of the government bond market, as there may be better areas to potentially add value. Another reason, more probable and even more powerful, is the consideration with which we began this note: too much uncertainty.
1 - In late November 2011, Italian 10-year yields were over 7.2% and Spanish 10-year yields were over 6.6%.
Margin of safety refers to the difference in the market price of a security and its estimated intrinsic value.
Developed countries refers to those that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.
The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The federal funds rate (fed funds, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Investment risks
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
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