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Ever since the Federal Reserve inserted itself as the prevailing influence on long-term interest rates, questions have loomed about where rates might be with less intervention from the central bank. Should the Fed eventually curtail its market activity, economic and market forces would again become the driving factors behind interest-rate movements, suggesting a significantly higher 10-year Treasury yield based on historical measures and a recently released estimate from the U.S. Treasury Department itself.
How close is this transition? While periodic, weaker than expected economic reports may prolong the Fed's $85 billion in monthly asset purchases, the noise has grown louder about the mounting risks from stockpiling more than $3.2 trillion of assets on its balance sheet. So, the Fed may not require too much additional economic strengthening before it reduces its asset purchases, which might allow long-term interest rates to more accurately reflect economic and market conditions.
For investors with allocations benchmarked to the Barclays U.S. Aggregate Bond Index,1 a more "normal" interest-rate environment could indicate zero total return for up to five years, considering that nearly 80% of the traditional fixed-income benchmark consisted of government and government-related securities, as of April 30, 2013.
One indication of where the 10-year Treasury yield could be with less influence from the Fed is gross domestic product (GDP), which, on average, has been remarkably closer to the long-term real yield on the 10-year Treasury note. Indeed, the average expansion of real GDP was 2.53% during the 20-year period that ended on February 1, 2013. This was only 4 basis points (bps) below the real yield on the 10-year Treasury note during the same time frame.2
Recently, there was a significant break in this coordination with the real yield on the 10-year Treasury dropping into negative territory, while real GDP expanded at a pace of 2.5% in the first quarter of 2013.3 While this historical relationship could be restored with either a decline in GDP or an increase in the real 10-year yield, an increase in rates may be the more likely scenario, given the influence of the Fed's prolonged purchases of Treasuries. Thus, if the typical state of the real 10-year yield is closer to 2.5% and the Fed is targeting an inflation rate of 2.0%, this could put the nominal yield closer to 4.5%.
One could essentially arrive at the same figure using the Fed's long-run projection for GDP, which was 2.4% in its Summary of Economic Projections from late March 2013 and its long-run inflation target of 2.0%.
A different method of estimating where long-term rates could be is by looking at historical relationships along the yield curve. And with the Fed anchoring the front of the curve near zero, the front of the Treasuries curve has remained in a similar position, with the three-month Treasury bill yielding 5 bps as of May 1, 2013, according to the Fed.
Before the Fed implemented its zero-bound policy, however, three-month Treasury bills had posted a long-term real return—comprised essentially of their real yields given their minimal price movement—of 1.2% from 1954 through 2007.4 (See Table 1.) If this is the historical relationship between the yields on Treasury bills and inflation, then looking forward with an expected inflation rate of 2.0% brings the potential nominal yield on the three-month Treasury bill to 3.2%. And with the long-term differential between the 10-year note and the three-month bill of 1.5%, this suggests a 10-year yield of 4.7%.
Source: Federal Reserve, Bloomberg, Journal of Financial Planning, and the Department of the Treasury.
* 20 years ended February 1, 2013. The average expansion of real GDP over the same time period was 2.53%.
† From 1954 through 2007. Past performance is no guarantee of future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.
The concept of a 10-year Treasury yield in the area of 4.7% is also supported by the long-term yield-curve relationship between the fed funds rate and the 10-year note, which has been about 1.0%. This difference is, interestingly, lower than the one with the three-month bill, and that may be explained by investors' expectations for a reduced pace of inflation or further interest rate hikes once the Fed has already tightened monetary policy.
Therefore, with the Fed projecting that the long-term level for the fed funds rate is 4.0%, the yield differential of 1.0% to the 10-year note could suggest a yield of about 5.0% in a market with less central bank intervention.5
The similar outcomes of interest-rate projections in a more "normal" interest-rate environment are supported by a recently released report by the U.S. Treasury Department about potential changes in interest costs on the federal debt once the Fed starts exiting its policy accommodation. And the report explains that the main driver in a significant increase in future borrowing costs could be a higher 10-year Treasury rate of 4.3% over the next several years.6
Although interest rates have been on a declining trend for more than three decades, much of that has been without the Fed's broad influence on long-term interest rates, which may be set to decline over the next several years.
Therefore, in an environment where the 10-year Treasury yield could increase by up to three percentage points over the next five years, a consistent move among interest rate-sensitive markets could indicate a price decline of about 15% on the Barclays U.S. Aggregate Bond Index, given its duration of about 5.3 years as of mid-May 2013.7
As this yield normalization takes place, the index's yield of about 1.80%, as of mid-May, could drift higher and mostly offset the loss in price, which could translate to a five-year total return of about zero.8 For investors with allocations benchmarked to the traditional fixed-income benchmark, five years could represent a prolonged stretch of essentially standing still.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
There is no guarantee that the U.S. Treasury market will perform in a similar manner under similar conditions in the future.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Glossary of Terms:
A yield curve is a measure at a given point in time of how interest rates change based on maturity terms.
Gross domestic product (GDP) measures the good and services produced in an economy over a specific timeframe.
A basis point is one one-hundredth of a percentage point, and 100 basis points is equivalent to 1%.
A nominal yield is the stated yield on a bond. A real yield is the nominal yield minus the rate of inflation.
Duration is the change in the value of a fixed-income security that will result from a 1% change in interest rates, taking into account anticipated cash flow fluctuations from mortgage prepayments, puts, adjustable coupons, and potential call dates.
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.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.