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Market View

Market rates in the United States may flirt with the “zero bound” and even lower levels, but policy-driven short-term rates are likely to be a different story.

 

In Brief:

  • The depth and tenacity of low interest rates since the 2008-09 Great Recession has raised fundamental questions about the future effectiveness of U.S. monetary policy.
  • However, against the backdrop of a still relatively strong U.S. economy, the U.S. Federal Reserve (Fed) has, in our view, little reason to implement a negative interest rate (NIRP) policy.
  • The assumption that interest rates can never go below zero has been so fixed that the sudden appearance of negative rates in many other nations in the 21st century has put investors in uncharted territory.
  • While some investors are buying negative yielding bonds in the hope that prices will rise, they are likely to experience a loss if they hold such bonds to maturity.

 

The proliferation of negative yielding debt around the world (a Bloomberg report put the total at $17 trillion as of August 30, 2019) has helped attract global capital to U.S. Treasuries, where yields—even as they sit near historic lows—look substantial by comparison with the yields of sovereign bonds outside the United States. Investors are also attracted to the relatively strong U.S. economy at a time when global growth shows signs of slowing.

Large institutional buyers, particularly pension funds and insurance companies with long-term liabilities that stretch out over many decades, are obligated by regulators to adhere to a benchmark which includes substantial holdings in long-term government bonds, historically considered to be a relatively risk-free position. This may account for the institutional demand we saw recently for Germany’s 30-year debt issue at a negative yield, bewildering as those purchases may have seemed at first glance.   

And it also raises the question: Will the search for seemingly low-risk, long-term government securities be the final push that sends U.S. Treasury interest rates into negative territory? Interviewed on CNBC recently, former Fed Chairman Alan Greenspan, said that “It’s only a matter of time.” The 30-year U.S. rate hit an all-time low of 2.06% on August 14, 2019.

A Decades-Long Downward Trend
Globally, real interest rates (i.e., the rate of interest an investor or saver receives after allowing for inflation) have been falling for over three decades, averaging 5% in the 1980s, 4% in the 1990s, 2% so far in this century, and around zero or slightly negative today, according to Andrew Haldane, former chief economist at the Bank of England. In a June 29, 2015 speech, Haldane offered the chart below as evidence, noting the below-zero bound status then and suggesting that such was the “new normal” for the foreseeable future—a prediction that has certainly proved valid in Europe and Japan.

 

Chart 1. Global Real Rates Have Been Declining Since the 1980s
10-year global “real” rate (per cent)*(1980-2015)
Source: Andrew Haldane, “Stuck,” speech delivered June 29, 2015, Open University, London. *The global “real” rate is based on the average 10-year yield of inflation-linked bonds in the G7 countries (excluding Italy). The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.

 

The explanations for this fall in global real rates vary widely and include excess savings in the East, deficient investment in the West, and demographic trends signaling aging populations in many developed nations. But, whatever the reason, the depth and tenacity of low interest rates since the 2008-09 Great Recession has raised fundamental questions about the future effectiveness of U.S. monetary policy which, historically, has relied primarily on the adjustment of short-term interest rates as a tool for managing the health of the economy.

No NIRP for Now
Market rates in the United States may flirt with the zero bound and even lower, but policy-driven rates are likely to be a different story. Outside of managing short-term interest rates (primarily the rate that banks earn on their overnight deposits), the Fed has a number of tools by which it can achieve further accommodation, should an economic slowdown occur, including the unconventional policies employed during and after the Great Recession, such as forward guidance to manage expectations, and quantitative easing, which involves the buying of securities from the market in order to increase the money supply.

The Fed could even try to manage the yield curve. The Bank of Japan (BOJ) is the only major central bank in recent history to experiment with Yield Curve Control (YCC), which involves a commitment to buy medium or long-term bonds should their rates rise above a stated target rate. The idea is that once bond markets learn to trust the central bank’s commitment, the target price would become the market price. Lower interest rates on government securities would be expected to feed through to lower rates on mortgages and corporate debt, which would encourage spending and investment. YCC is just one piece of the BOJ’s policy effort to lift inflation.

We believe the Fed will exhaust these and other options before it implements a negative interest rate policy (NIRP) for a number of reasons:

  • With U.S. inflation at close to 2% and an economy that is still growing, this is not the time for emergency rates, which NIRP would provide. While there is always the possibility of a major financial shock, such as the housing market crisis in 2008-09, we believe there are no real financial excesses in the U.S. economy to create such a disturbance today or in the near future.
  • Countries where NIRP has been tried—including Switzerland, Sweden, and Denmark—have used the policy to stem the flow of capital into their comparatively small economies. Such flows might prove disruptive to their housing or other markets. On the contrary, capital flows are not a major issue for a large open economy like the United States.
  • Negative interest rates are not sustainable for a long time, in our view. Implementing NIRP could potentially send a signal that a bad economic situation will continue, making it difficult to exit the policy, and creating unforeseen consequences. Persistent negative rates would be an indication of a deeper fundamental problem, such as the so-called “zombie”1 corporations of Japan that couldn’t officially be restructured and so have been a drag on the economy.

Implications for Bond Investors
The recent bond rally pushed yields on more than $17 trillion of global debt below zero, meaning investors in such debt are likely to experience a loss if they hold securities with negative yields to maturity. While some investors continue to flock to these securities with low yields, in hopes that the price of the security with a negative yield will continue to rise, other investors are taking a more cautious approach: shifting to high-quality, short-dated debt securities. Short-term bonds historically have been more insulated from major swings in interest rates, and, thus, we believe could be more protected if there were to be a sell-off. High-quality bonds potentially provide protection against credit risk.

Going Forward
Like the Bank of Japan and the European Central Bank before it, will the U.S. central bank struggle to stimulate the economy, with interest rates already near zero and inflation expectations so low?  That appears to be what the market is worried about. In our opinion, out of an abundance of caution, the Fed will pursue other options long before adopting NIRP.

Monetary policy aside, it’s also interesting to remind our readers that, for the U.S. economy in general, low inflation and interest rates at the zero lower bound are not necessarily a bad thing. The late economist Milton Friedman suggested that the optimum economic scenario for an economy is slight deflation and nominal (before taking inflation into account) interest rates at zero.

But it will definitely be difficult for the Fed to help stimulate the economy in the event of a recession in an environment where interest rates cannot be lowered. We continue to believe that the likelihood of a recession in the near future is low, but the United States is close to a zero interest-rate environment today, and that raises the risk of Fed policy falling short of its dual mandate of price stability and maximum sustainable employment when the time for stimulus arrives.

For additional insights from our experts on negative interest rates, look for an upcoming Fixed Income Insights article on lordabbett.com. 

 

1During the period known as the “lost decade” after the collapse of the Japanese asset price bubble in 1990, Japanese banks continued to support weak or failing firms with discounted interest rates and easy lending terms. These were called the “zombie” firms.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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