Income investors keep reading that interest rates are rising, so what they observe in the marketplace may be perplexing. Since November 2015 the Fed has increased the key Fed Funds rate by 1.75 percentage points (from 0.25% to 2.00% for the upper bound of the target range).
Over the same period, the ten-year U.S. Treasury yield has climbed by only 0.75 percentage points (from 2.22% to 2.97%). Earlier this year, JPMorgan CEO Jamie Dimon, who one must assume knows a fair amount about interest rates, predicted that the ten-year rate would rise to 4% in 2018. So far, however, that rate has failed to stay above 3% for any extended period. What accounts for stubbornly long-term yields?
10yr US Bond Yields Don’t Typically Soar When the Fed Funds are Rising
Fed Fund Target Rates vs 10yr US Treasury Bond Yields (1990-2018)
SOURCE: Bloomberg Professional Services
To begin with, a “Fed interest rate hike” specifically means an increase in the interbank overnight lending rate, the above-mentioned Fed Funds rate, which the Fed directly controls. Long-term interest rates are ordinarily not managed by the Fed.* Economist Gary Shilling recently noted that the longer the maturity of a Treasury bond, the less closely it follows movements in the Fed Funds rate. Inflationary expectations become a more important determinant as maturities extend. It is typical, rather the exception, that long-term rates move up more slowly than short-term rates when the Fed starts to hike.
Even aside from the Fed’s activities, many investors find it surprising that long-term interest rates have not busted through 3% by now. Interest rates reflect demand for capital, which generally increases as economic activity picks up. The recently reported 4.1% GDP gain in the second quarter connotes a very strong economy, notwithstanding questions about the sustainability of that level of growth. In addition, labor markets have gotten tighter as unemployment has fallen to 3.9%. That raises the prospect of accelerating wage increases and higher inflationary expectations, which are in turn associated with rising long-term interest rates.
Here are some factors that have sustained the demand for and prices of U.S. Treasury bonds, effectively putting a cap on Treasury yields:
Fear that an escalating trade war will weaken the economy has driven investors to the safe haven of Treasuries.
The rising value of the dollar in currency markets has made U.S. investments more attractive to foreign investors. As the dollar appreciates, the value of their U.S. holdings rises in terms of their home currencies.
U.S. Treasuries continue to offer much higher yields than government bonds of competing countries such as Germany and Japan.
For the last few years we have believed that fears of a major upside breakout on long-term Treasury yields were overstated. So far, the market has vindicated that belief and we continue to manage our clients’ portfolios accordingly. At the same time, we are keeping a sharp eye out for any sign of a rise in the secular rate of inflation and are prepared to revise our strategy if conditions begin to favor a bigger increase in long-term interest rates.
*In response to the Global Financial Crisis, the Fed in 2008 began intervening in the long-term market by buying massive quantities of government bonds and mortgage-backed securities. While much of that paper remains in the Fed’s hands, it is not currently pushing long-term bond yields down by adding to those holdings.