With our expectations for a Fed rate hike of 25 bps in December, and two more 25 bps hikes in 2017, should clients/investors be selling their bonds? The answer is an emphatic no!
In my last blog post I highlighted the significant back-up in US government bond yields on expectations that Trump’s policies will lead to higher inflation down the road. For example, the US 10-year Treasury yield has surged 60 bps to 2.40% since the November 8 election day.
With the back-up in bond yields (and declines in bond prices) we’re once again hearing from the financial media and so-called “experts” that the 35- year bull market in bonds is about to end and that investors should rush out and sell their bond positions before it’s too late.
If I had a dollar for every time I’ve heard this in recent years I would have about $25 or just enough to buy a Trump “Make America Great Again” hat.
So Ryan, which is it? You see further Fed rate hikes but continue to recommend exposure to bonds?
Essentially, we believe interest rates have bottomed and will grind higher over the next few years but believe the Fed will be glacially slow in raising interest rates and see rates remaining low from a historical context. Here’s why.
First, we see interest rates remaining lower than normal because the US government simply cannot afford significantly higher interest rates given their ballooning US debt load. While the Republicans like to blame the Democrats for the out of control deficits and debt load, the reality is both parties have contributed to the massive US debt load. Under President Bush II, US federal government debt doubled from roughly $5 trillion to $10 trillion, and under President Obama, it doubled again from $10 trillion to the current $19.9 trillion level. Incredible! A couple of wars and a major economic meltdown can add up pretty quickly.
Now what’s interesting is that the interest expense on this debt as a percentage of the overall US budget has actually declined from roughly 20% in the 1990s to just 10% today. How can this be? The answer is that as government bond yields have declined to historic lows, this has more than offset the impact from the dramatic rise in debt over this time.
With the US government owing nearly $20 trillion, if interest rates were to jump materially from their current low levels this would dramatically increase interest servicing costs, putting serious stress on the US budget and spending programs. The Congressional Budget Office (CBO) projects interest costs to rise 250% from current levels if the 10-year yield rises to 4% by 2026. By 2030 they see interest costs representing over 14% of the federal budget versus 10% today, and rising further in future years. Given this, and the fact that the US population is aging, which will only add to increased costs in the coming years, the US government can simply not afford significantly higher interest rates, which we believe will help to keep them well anchored at historically low levels.
US Gov’t Interest Expenses Have Declined With Low Rates
Source: Bloomberg, Turner Investments
The second reason we see US (and Canadian) interest rates remaining relatively low is that they are approaching “fair value” based on our model for forecasting interest rates. I’m going to get a bit geeky here but I built a financial model using different inputs (e.g., inflation, economic activity), that has helped explain/predict the level of the US 10-year government bond yield. My model, which has a high level of predictability (high R-squared for you quant geeks), currently suggests “fair value” for the US 10-year yield of 3% compared to current levels of 2.4%. So, we see interest rates rising a bit further from current levels but for the US 10-year to be capped around 3% over the next year.
Turner Bond Model Suggests 3% 'Fair Value' US 10-Yr Yield
Source: Bloomberg, Turner Investments
Finally, another important reason why we see interest rates remaining low is due to the aging demographics in the US and across the developed nations. Economic growth over the long-run is driven by two key factors – population growth and productivity gains. Both of these factors are in decline, in large part due to our aging population. Below I illustrate this with US population growth declining from 1.7% annually in 1960s, to 1.4% in mid-1990s, to just 0.7% today, according to The World Bank.
The simple fact is that while Garth Turner can continue to pump out six meaty blog posts a week, many of his contemporaries are just not as productive as us 40-year olds, or those pesky millennials. A millennial these days can order a low fat mocha Frappuccino from Starbucks, pay a bill on their mobile phone, upload pictures from the previous night’s dinner at some trendy restaurant on Instagram, and try to save the world all at the same time! I can barely write this blog and drink my Earl Grey tea without spilling it all over myself.
So millennials, the next time you want to blame your parents and grandparents for leaving this world and the future in worse shape than their parents, remember to thank them for being old and them greatly contributing to the current record low interest rates that are allowing you to lever up and buy that million dollar home.
Sorry I went on a rant there, but to conclude, we see interest rates slowly grinding higher over the next 1-2 years, but see them remaining low from a historical perspective, and why we believe investors should not rush out and sell all their bond holdings. They continue to be important in portfolios as they help to provide balance and stability, while also providing a little insurance just in case the millennials are correct that the world is going down the tubes.
Declining Population Growth Should Help Anchor Rates