The Message of the Bond Market

At the beginning of the year, most market strategists were in agreement that interest rates were going to rise in 2017. The reasons varied: some saw inflation climbing, pushing yields higher; others worried about bigger budget deficits; a few blamed the Federal Reserve, which was thought to be planning to raise short-term interest rates two or three times and shrink its balance sheet. Whatever the reason, interest rates were expected to head higher, so seeing the 10-year U.S. Treasury yield here at 2.3% is a surprise.

To many pessimists on the economic outlook, the drop in yields on the 10-year from 2.6% is a sure sign that the economy is weakening. After all, this expansion is almost eight years old and it is reasonable to expect a slowdown or even a recession. The disappointing employment report for March showing only 98,000 jobs were created may have been the first sign of trouble. Others believe the uneven start of the Trump administration in putting its pro-growth agenda to work is a reason to buy bonds and avoid the risks of increased equity exposure.

One political factor that may be influencing interest rates is the concern that the new administration under Donald Trump may not get much legislation through Congress. The failure to repeal the Affordable Care Act was the first sign of legislative difficulties. Recent reversals of positions by the president include China as a currency manipulator, NAFTA as a bad trade deal, involvement of the U.S. in Syria and Afghanistan, NATO as an obsolete alliance, Russian relations and renewing Janet Yellen’s term as Federal Reserve Chair. These reversals confused voters and investors on where the president really stands and diminished confidence in the positive pro-growth outlook. Some of his conservative supporters feel he is letting them down. This disappointment may be reflected in the lower interest rates and the modest stock market correction we have seen since March.

Students of economics may look at the growth of debt as a negative. World debt is a discussion issue in almost every meeting I have with clients. According to a study by Ned Davis Research, world non-financial debt has increased from $37.5 trillion in 2000 to $103.5 trillion in 2016, an almost three-fold rise. In the United States federal debt has more than tripled from $6 trillion in 2000 to $19 trillion today. This enormous surge in debt has not caused substantial investor alarm. Even many conservatives, who adopted the credo that we cannot pass on a huge debt obligation to our grandchildren, have virtually stopped talking about it. You would think that these higher debt levels would push interest rates up because they represent increased financial risk, but that has not happened.

We have actually been blessed by this decline in interest rates in the United States. In 2000, the total interest cost of servicing the federal debt was $360 billion, based on a blended interest rate on government bonds of 6%. Today, the blended interest rate is 2.1% and the total interest cost is $400 billion, only $40 billion more on a debt burden three times the size of its 2000 level. If interest rates on government securities rise 1%, the cost of debt service would increase almost $200 billion, offsetting most of the budget cuts being proposed by the Trump administration.

Why have interest rates declined when debt has increased and the economy is growing? I have long believed that at least part of the answer is the considerable expansion of central bank balance sheets. The surfeit of liquidity around the world may be playing a role in keeping interest rates low. Central banks in the U.S., continental Europe, the United Kingdom and Japan have increased their balance sheets by $10 trillion since 2008. In my opinion, as much as three-quarters of those funds found their way into financial assets, inflating price-earnings ratios and keeping interest rates low. Only one quarter of that increase was invested in the real economies of those countries and regions that were the intended beneficiaries of the monetary expansion. Now many of the managers of that capital are risk-adverse and are searching for places to park their money until the outlook improves. That is why you have negative interest rates in Europe and Japan.