The direction of interest rates is notoriously difficult to predict, and with economic uncertainty rising around the world, it isn’t getting any easier.
After years of interest rates hitting new lows, they quickly jumped after the November elections. While the magnitude of the jump was not huge, the move was widely attributed to Donald Trump being elected president. Based on Trump’s promises on the campaign trail, many investors expect a combination of economic growth, infrastructure spending and increased government borrowing to lead to higher inflation and, in turn, higher interest rates.
Of course, the global bond market is enormous and fluctuates based on more than the current news cycle. That market is estimated to be more than $100 trillion, with the U.S. bond market making up less than half of the total. The amount of bonds traded on a daily basis is a tiny fraction of the market’s total value, and changing expectations can lead to big moves in interest rates fairly quickly.
While bond markets may be more volatile during the Trump presidency than they have been over the last several years, investors must not overreact as interest rates fluctuate. When considering just how much volatility to expect, and how to avoid losing money along the way, it is important to look back at the historical movements of interest rates and the bond market.
A Historical Perspective On Interest Rates
Because interest rates and bond prices move in opposite directions, investors need to think about interest rates when deciding on a strategy for their bond portfolios. Here are three recent examples that we believe are useful.
First, from 1977 to 1981, the Federal Reserve increased the federal funds rate from below 5 percent to 20 percent to stop inflation from spiraling out of control. Long-term rates also spiked during this period, and many bond investors who decided to sell bonds before they matured saw double-digit losses. However, after 1981, interest rates descended steadily, with some ups and downs along the way, until the present. Bond investors who locked in high rates profited handsomely, and falling rates steadily boosted bond returns for decades.
Second, from June 2004 to June 2006, the Federal Reserve steadily pushed the federal funds rate higher in 0.25 percent increments, from 1 percent to 5.25 percent. Because investors widely expected the increases and the Fed communicated its plan ahead of time, the U.S. bond market remained calm throughout this period and provided positive returns. Inflation remained tame throughout. Interestingly, longer-term interest rates rose only slightly during this time. While this was a calm period, illustrating that bond investors can still profit during periods of rising rates, it also preceded the financial crisis of 2008-09. In hindsight, many investors blamed the Federal Reserve for lowering rates to 1 percent in the first place, which led to a real estate bubble and aggressive borrowing.
Finally, from December 2008 to December 2015, the Federal Reserve kept the federal funds rate at near-zero levels to stimulate the economy during and after the financial crisis. Long-term rates fell to new lows during this time, with some short-lived upturns along the way. Bond investors who chose not to “fight the Fed” were rewarded. Fears of deflation appeared from time to time, but prices rose slightly overall during the period.
Investors can learn several lessons from these historical examples, but the first and most important is to be wary of inflation. While it has been quite some time since we have seen significant inflation in the United States, it can be hard to stop, not to mention painful, once it gets going. Seeing interest rates in the U.S. triple, quadruple or more in response to inflation may be hard to imagine, but it has happened before and it could happen again. While the Fed would like to raise rates gradually, as it did between 2004 and 2006, if inflation starts climbing too fast, the central bank may have to raise rates more rapidly, which could choke off economic growth and lead to increased market volatility.
Two scenarios in particular are most likely to lead to higher inflation. The first is a labor shortage, in which employers would have no choice but to increase wages, then raise prices to offset those new higher wages. The second is a system shock, such as the U.S. oil embargo in the 1970s. When the supply of goods is overwhelmed by demand, prices can quickly spike, leading to broader inflation setting in. Either or both of these scenarios could play out in the next five years as a result of labor shortages or increasing protectionism in the form of tariffs or trade wars with other countries.
One more lesson is that investment markets, not the Federal Reserve, control long-term rates. Sometimes the federal funds rate and long-term rates move in the same direction, and sometimes they don’t. It is important to try to understand the direction of both, especially when they move in opposite directions.
Finally, investors need to understand that, after 35 years of falling rates, it is mathematically impossible for bonds to provide the same level of returns that they have since 1981. Bonds still have a place in a diversified portfolio, but investors should temper their expectations going forward.
The Impact Of Foreign Bond Markets
When thinking about U.S. interest rates, investors must also consider what is happening in bond markets around the world. In the last few years, we have seen negative interest rates take hold in many countries as foreign central banks pushed rates below zero in an attempt to further stimulate their economies. With trillions of dollars of global bonds now trading with negative yields, investors cannot ignore this phenomenon.
Negative rates do not appear likely in the U.S. anytime soon, and for now, it looks as though rates will rise, not drop. But while many academics previously considered zero to be the natural floor for interest rates, we have seen that this is no longer the case. If the U.S. experiences an economic recession before rates have a chance to rise significantly, it is possible that we could eventually see stimulus measures that include negative rates.
Even if we never see negative rates at home, investors still need to understand the implications that come with trillions of dollars of debt with negative yields abroad. As our interest rates rise, our debt will become more attractive to foreign investors, and many of them could pile into U.S. bonds, pushing yields back down again. If foreign countries relax their stimulus efforts and allow interest rates to climb, the change should make it easier for U.S. rates to climb as well.
Where Rates Go From Here, And What To Do About It
At Palisades Hudson, our investment committee has spent a significant amount of time discussing interest rates and bond investments, both before and after the November election. We do not believe the country is headed for a repeat of 1977-81, but we also do not expect interest rates to stay low forever. We continue to monitor domestic inflation and negative interest rates abroad, and we expect both to have a major impact on the direction of interest rates here.
The cost of being wrong about interest rates can be significant if an investor is overly aggressive and rates rise. At Palisades Hudson, we recommend investing in bonds to reduce volatility in an investment portfolio and to generate interest income. Therefore, we do not recommend taking outsize risks in a bond portfolio. The potential downside is too great, and the potential returns are not enough to justify the risk.
As always, investors should remain diversified when building a bond portfolio. We recommend balancing bond exposure across multiple issuer types, including tax-exempt municipal bonds, corporate bonds, asset-backed securities and U.S. government bonds. The core of our bond portfolios is investments in short-term, high-quality bond funds that should maintain their value regardless of interest rate fluctuations. We also recommend low-risk arbitrage strategies and bond investments that stand to do well during periods of rising rates, such as floating-rate bond funds.
It is important to hedge against the risk of rising rates, but it is also important to hedge against the risk of rates remaining low for the long term. Investors may find it appropriate to invest a portion of a bond portfolio in intermediate-term bonds with higher yields to generate higher returns if rates stay low or rise gradually.
The Fed’s goal is to gradually raise rates in the future without interrupting economic growth, similar to the period between 2004 and 2006, and we believe this is a real possibility. Historically, inflation in the U.S. has averaged about 3 percent, and the Fed would like to eventually move the federal funds rate to around this level. One would hope that intermediate-term rates would stabilize a few percentage points higher than the fed funds rate, which would compensate investors for the additional risk of lending for longer periods of time.
There is little margin for error here, and the risk of overshooting these targets is great. We remain concerned about the risk of rapidly rising inflation, and investors who are waiting to see more inflation before they adjust their portfolios may not be able to react before it is too late. Bond investors should hope for the best but prepare for the worst, and invest accordingly.