It has been a long time coming but we have finally been given a wake-up call: the 10-year US Treasury bond yield has gone above 3%. So, now what? Should we prepare our fixed income portfolios to hedge interest rates in case of further hikes? Or should we increase the duration to take advantage of potential corrections below 3%?
In a time before Central Banks routinely employed cash injections and mass bond purchasing, textbooks on macroeconomics traditionally taught that 10-year yields responded to a simple formula: expected growth + inflation expectations. So, if we consider just these two factors and we believe the consensus forecasts for the coming years are valid, we could conclude that we will soon be grazing the 5% mark for the 10-year US Treasury bond. The reality is not all that simple and recent years have served to cast doubt on some of the principles we learnt during our studies, as they reflect a new reality in the interrelationships among economic variables. For instance, after several years of unlimited liquidity, inflation is only now beginning to rise slightly or even though the Federal Reserve increased official rates and four hikes are expected for this year, the dollar has weakened.
Some official projections for US economy growth include: IMF: 2.9% for 2018 and 2.7% for 2019; and OECD: 2.9% for 2018 and 2.7% for 2019. Yes, the figures look good. No doubt about it. But they do not point to accelerated growth that could justify inflationary pressures and aggressive rate hikes and we cannot rule out the possibility that these forecasts will fall in the coming quarters. After 35 straight quarters of economic expansion in the US, we may beat the record of 39 quarters set in the 90s, which culminated in the technology bubble (“dotcom”). Let’s face it, until Trump’s fiscal stimulus peters out, the tailwind will continue to blow for consumption, investment expenditure and the real estate sector. However, we are not looking at an abrupt rally, but an ongoing slow and steady pace for growth. In other words, even if we stick to the traditional factors that we mentioned, which determine the 10-year yield, we are not anticipating an environment that justifies much higher rates than now. We might also add other “non-traditional” factors into the equation, such as the impact of the behaviour of some very influential players in the sovereign debt market like China (largest foreign holder of US Treasury bonds), insurance companies and sovereign wealth funds.
Nor are we convinced by those who predict an imminent recession and a return to yields below 2% for the 10-year US bond. One of the arguments that has become popular among proponents of this position relates to the yield curve inversion. That is to say, a lower interest rate for the 10-year than the 2-year bonds. Historically, the inverted yield curve has been one of the best indicators of recessions. In fact, all the recessions suffered by the US since the 1960s have been preceded by yield curve inversions. Recently, the slope has reduced, but there is still a 50-basis point spread between the 10-year and the 2-year bonds. And we believe that this reduction is due more to the non-traditional dynamics that we have mentioned, which are sustaining the 10-year yield level, than to signs of an imminent recession.
And what about the voices warning us of another consumer delinquency crisis caused by official rate hikes? The market is discounting a total of four rate hikes by the Federal Reserve for this year. Despite the rise in the short rates, which brings an increase in consumer credit costs, we are still not seeing alarming increases in the delinquency rate among the various classes of consumer loans. If rates continue to increase more aggressively, we could indeed see this but, for now, it is not our base case.
Even if we think that the rate hikes will not be sufficiently aggressive to rain on our parade, we do need to be prepared for unexpected summer downpours. We choose not to fully hedge interest rate risk, but we are carefully looking at the relative value and potential risks. With a spread of just 15 basis points between the 5 and 10-year US Treasury bond yields, can we justify assuming an additional 4 years of duration risk? We do not think so.
Column by Meritxell Pons, director of Asset Management at Beta Capital Wealth Management, Crèdit Andorrà Financial Group Research.
For Funds Society, Madrid
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For Alicia Miguel