2 Views: How Low Can Rates Go?
Kevin Flanagan
Senior Fixed Income Strategist
WisdomTree
Bob Smith
President & CIO
Sage Advisory Services
Fixed income markets have been on a wild ride this year. A record $15 trillion of global bonds have negative interest rates, according to Bloomberg, and even U.S. yields are tumbling to jaw-droppingly low levels. Could the U.S. join Europe and Japan with negative interest rates? Will the Fed cut rates only a few times, or more deeply than that? And how should investors position their fixed income portfolios?
Those are a few of the questions ETF.com raised with four fixed income experts. Below is part two, which features answers from Bob Smith, president and chief investment officer of Sage Advisory Services, and Kevin Flanagan, senior fixed income strategist at WisdomTree.
Read part one here: 2 Views: Are Negative US Rates Coming?
ETF.com: The Fed hinted that its last rate cut was more of a midcycle adjustment than the start of a long rate-cutting cycle. The market doesn’t believe that. What do you think?
Kevin Flanagan: If you were to look at fed funds futures before July’s Fed meeting, a total of 100 basis points of cuts were priced in. But unless the wheels really fall off the bus in the markets, and unless financial conditions really tighten, we are in the camp that thinks the Fed will do 50, maybe 75 basis points of cuts, not the 100 that the market is expecting.
Bob Smith: Regardless of recent Fed policy statements on interest rate adjustments, we believe the markets are experiencing a wave of easy money policies around the globe (New Zealand and the Philippines are last week’s examples) from the advanced economy and emerging market central banks alike.
We further believe more easing is to be expected in light of the economic softening underway in the U.S. industrial sector and around the world. To date, the U.S. consumer sector has been comparatively more buoyant, but concerns are now emerging over a noticeable softening in various consumer economic activity metrics as well.
We think the Fed will remain in a dovish mode and prone to near-term, quarter-point rate reductions. Clearly, the broad market shares this view, as consensus has moved from an expectation for two hikes less than 12 months ago to the current 60% plus consensus forecast of almost four cuts over the next year.
ETF.com: There’s growing chatter about interest rates in the U.S. hitting zero, or even going negative like they are in Europe. Is that realistic, or absurd?
Smith: The reasoning behind the chatter on U.S. rates reaching zero or negative levels is largely based upon an unsubstantiated view that foreign central banks and the Fed are bound to follow similar forms and degrees of monetary policies in some measured lock-step process, even if their respective domestic economic circumstances don’t yet offer fundamental justification for such moves.
The U.S. has the strongest economic circumstances compared to most of the economies that find themselves caught in a vortex of negative rates (45% of all non-U.S. government debt).
There are arguments to be made about the need to reduce rates to maintain currency parity with those major U.S. trading partners that have lower or negative rate structures, but the Trump administration doesn’t seem to want to pursue this policy at this time. Based on what we know today, it would be hard for us to imagine an economic reason or policy objective that would clearly qualify the need for negative interest rates in the U.S.
Flanagan: A lot depends on where we go from here in the risk markets. Does the trade war really heat up to the point where it has a significant impact on the U.S. economy? So far, it hasn’t. There’s been some slowing, but we are growing so far this year around 2.5%. If we’re still at 2.5% growth and a 50-year low in unemployment, it seems difficult to tip to zero and/or negative rates.
You have to consider that, with the recent budget deal, we’re going to be running $1 trillion deficits. Treasury is going to need to finance that. There are a number of factors that would come into play that would prevent negative rates from happening.
ETF.com: Where do you see the 10-year Treasury going in the short or long term?
Flanagan: For investors, if you’re looking for a line in the sand, the all-time, intraday low for the 10-year Treasury was 1.318%. If you were to break through that, then you’re in uncharted territory. Unless things really deteriorate, it looks to me that the market would have a tough time penetrating that level.
Smith: We think that the perfect storm of easy monetary policy, emerging economic weakness and demand for high quality income in an environment of less supply will serve to eventually bring U.S. rates lower, with the 10-year Treasury possibly retesting its 1.3% low in the next few months.
This could be exceeded if risk markets enter a significant and prolonged sell-off exacerbated by weak seasonal technical factors and a growing international U.S./China trade war.
ETF.com: In this environment of plunging Treasury yields and uncertainty about the global economy, how do corporate bonds fare?
Smith: The U.S. corporate bond market is now more than twice the size and about 50% more leveraged than it was in 2007. When looking at total debt to GDP, the U.S. is about 250% leveraged to its economic output. This is a troubling trend in view of the global economic slowdown that’s emerging and the already historically low interest rates that exist worldwide.
It’s also important to keep in mind that slightly more than 50% of the investment-grade corporate bond market, or $3 trillion worth, is rated in the Baa/BBB category. We estimate half of the Baa/BBB rated bonds lie in the bottom half of the category, only a few notches away from junk status.
This is troubling when one considers that there’s already about $1 trillion of junk bonds outstanding. A significant increase in this amount due to rating downgrades and migration from the investment-grade sector are a growing concern for many market participants.
We’re suspicious of the higher leverage levels that are being carried by many nonfinancial companies in this economic environment, and as such, are looking to selectively reduce exposure to high credit beta positions.
Flanagan: If things ratchet up on the risk-off side, high yield spreads would underperform. Investment-grade spreads can widen, but they’re going to be more interest rate sensitive than high yield, so they could actually outperform high yield if we have a risk-off environment.
But on the flip side, what if cooler heads prevail in the trade war? Then more than likely, any widening in high yield spreads might be a buying opportunity.
ETF.com: How should investors position their fixed income portfolios? What types of segments should they overweight/underweight, and what types of ETFs should they buy?
Flanagan: We’ve been suggesting investors take a look at the barbell strategy. Think of it like the weight lifting device where you have a weight on each end of the actual barbell.
On one end, we would focus on our yield-enhanced strategy, the WisdomTree Enhanced U.S. Aggregate Bond Fund (AGGY). On the other end, we would focus on the Treasury floating rate strategy, the WisdomTree Floating Rate Treasury Fund (USFR). What’s nice about this is that you can toggle the weights back and forth between the two funds.
With these, you’re not making a big conviction bet on where rates are going to go. If you feel rates can continue to move lower and you’re looking for a little total return and some income, you have the yield-enhanced AGGY on one end.
But if the Fed disappoints and rates stay flat or move back up, then the floating rate mechanism of USFR would come into play and help mitigate some of that risk.
Smith: Given the current fixed income market environment, we think investors should be biased to longer-duration, high quality fixed income investments (e.g., long-term investment-grade corporates and Treasuries).
We’re underweighting high yield and emerging market debt as well as low quality investment-grade credit risk given the poor financial fundamentals and near-term technical factors that surround these sectors at this time.
We think that, while the mortgage-backed securities market suffered a recent short but sharp price adjustment due to the drop in interest rates, this has settled out, and the sector is now worth considering for those seeking a more stable, high quality liquid alternative to fully valued corporates or lower-yielding Treasuries.
Given the economic backdrop, it’s difficult to justify a position in inflation-protected securities or securities leveraged to an expectation for higher interest rates in the near to intermediate term.
If the rate environment continues to decline, we suspect that ultra-short-duration fixed income and money market funds or ETFs will come under pressure to retain assets. International non-U.S. fixed income ETFs will also likely come under pressure the longer negative rates persist in the major EU and Japanese markets.
Email Sumit Roy at sroy@etf.com or follow him on Twitter @sumitroy2
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