On April 25, the 10-year U.S. Treasury Yield closed at 3.03%, its highest yield since December of 2013 and finally eclipsing its long awaited milestone of 3%. Does this symbolize a new psychological level for investors and one perhaps creating widespread negativity in the markets? Some are saying so, but we would not agree.
Unlike most closely watched market milestones, this is one that has been seen and surpassed many times before and for extended periods of time. In fact, those of us who remember rate cycles of bygone eras can tell you the 10-year bond yield exceeded 15% in 1981. Perhaps this is a historical footnote for many, yet to some of us not all that distant a memory.
We survived that interest rate environment, and we suspect we’ll survive this one as well.
The 10-year yield also spent 50 years above 3%, from 1958 to 2008, and during that half century U.S. gross domestic product (GDP) averaged annualized growth of about 3½ %, and investors in the S&P 500® would have made about 90 times their money over that period. So in and of itself, there is nothing inherently dastardly about this 3% number.
Nonetheless, except for a very few days at the end of 2013 and beginning of 2014, the markets have not seen long-term rates this high in almost seven years, and that is creating some angst. Here are a few points to consider:
- First, we believe it’s important to remember that the eight years from 2008 to 2016 represented an anomalous interest rate environment unprecedented historically and unlikely to be repeated in the future. During this time, the Federal Reserve’s (the Fed) Quantitative Easing (QE) programs from 2008 to 2014 kept long-term rates artificially low, and when the time came in 2015 and 2016 to finally move tangibly away from its zero interest rate, the Fed became reluctant and failed to do so. As a result, we are just now catching up to an ascent in both short- and long-term rates that probably should have been in place more than a year ago.
- We also believe that often the key question is not whether rates are rising, or even how much they are rising, but why they are rising. There are several criteria, in our opinion, that have been creating upward pressure on rates. At the forefront of these is a strengthening economy that is approaching full employment and potentially reaching annualized GDP growth of 3%, a rate our economy has not achieved on a calendar year basis since 2005.
- We do not view inflation as a meaningful fundamental concern at this time based on the fact that the U.S. economy has actually been trying to create inflation for several years now. Inflationary trends have continuously run below the Federal Reserve’s target of 2% since the end of the Great Recession in 2009, and we would view reaching, or even modestly exceeding that target, as potentially favorable to the overall economic landscape.
- The impact of rising long-term interest rates on stock prices is one that should be evaluated against the backdrop of the overall macro economy and corporate earnings growth. At the current time, we see both of those continuing to be strong as we do believe U.S. GDP growth could challenge 3% in the year ahead and S&P 500® underlying earnings are expected to post year-over-year growth in the high teens. We do not necessarily see long-term bond yields above 3% as disruptive to either of these.
- The increase in long term rates will of course, in isolation, negatively impact bond prices. However with a strong credit environment, as evidenced by low corporate default rates, we believe fixed income investors can still benefit from lower duration portfolios with less interest rate risk that are able to apply proven expertise to identify improving credit opportunities. So with falling rates no longer a tailwind, bond investors may want to consider finding strong, credit-oriented portfolio managers to help achieve total returns.
We do not see this recent increase to 3% on the 10-year as an end point by any means and believe upward pressure on both short- and long-term rates could continue, based in large part on the following:
- We expect the current Fed tightening cycle to continue with at least two more hikes on the Fed Funds Rate between now and the end of the year.
- In our opinion, these future rate hikes will be in response to a strengthening economy that is approaching full employment, benefitting from the fiscal stimulus of recently implemented tax reform and the likelihood of inflation potentially reaching the Fed’s 2% target.
- The current yield curve is overly narrow in our opinion, at only about 0.50% between the 10-year and 2-year Treasury rates. Given the improving economic conditions we expect, this spread is likely to expand in the next year, further pressuring longer-term rates higher.
- The Fed is also in the process of reducing, or as it is also being referred to “rolling off,” its balance sheet to the tune of about $2.5 trillion over the next three years. All else being equal, this could also further pressure long-term rates higher.
This trend of rising rates should not come as a great surprise to most, and, as we stated in the Transamerica 2018 Market Outlook published in January, “long-term interest rates should continue higher and the 10-year bond yield could challenge 3%.” Along with that we also expressed our opinion that the U.S. economy would experience renewed momentum and that stocks should continue to be well positioned for gains in the year ahead. We also felt global economic growth should accelerate, potentially reaching 4%, which would be favorable for the international equity markets. We believe all of these should continue to be the case.
So from our vantage point, a 10-year yield of 3%, despite the “breaking news” type of attention it has been receiving in recent days, is just a number — a number that is likely to move higher but still fit current and anticipated market conditions appropriately.
About the author
Tom Wald is responsible for overseeing the investment and mutual fund product development functions and sub-adviser selection process. He also actively publicizes Transamerica’s investment thought leadership and products to advisors, clients, and the media. Tom has more than 25 years of investment experience and has managed large mutual funds and sub-advised separate account portfolios. Tom holds a bachelor’s degree in political science from Tulane University and an MBA in finance from the Wharton School at the University of Pennsylvania. He has earned the right to use the Chartered Financial Analyst (CFA®) designation.
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