VP, U.S. Rates Strategy
BMO Capital Markets
Chief Investment Strategist
State Street Global Advisors
Fixed income markets have been 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 Federal Reserve cut rates only a few times, or more deeply than that? And how should investors position their fixed income portfolios in this fast-moving environment?
Those are a few of the questions ETF.com raised with four fixed income experts. Below is part one, which features answers from Michael Arone, chief investment strategist for State Street Global Advisors, and Jon Hill, vice president of U.S. rates strategy for BMO Capital Markets. Read part two here.
ETF.com: The Fed hinted that its last rate cut was more of a midcycle adjustment rather than the start of a long rate-cutting cycle. The market doesn’t believe that. What do you think?
Jon Hill: The FOMC [Federal Open Market Committee] clearly desires to only implement a series of midcycle adjustments similar to the late-90s period. I’m skeptical they’ll be able to pull this off, as the overseas growth prospects look formidable. The fact that five- and 10-year breakevens are very low, despite market expectations for a cut that reflects the degree of skepticism that the Fed—try as they might—will be able to avert a global recession.
Michael Arone: Rate cuts are like potato chips—you can’t have just one. The Fed is likely to cut rates again at their next meeting Sept. 17 and 18. President Trump, market volatility, escalating trade tensions and weak economic data are putting additional pressure on the Fed to act faster and more aggressively. The probability is rising of an inter-meeting cut and/or a 50 basis points reduction in the target fed funds rate. Chances are growing the Fed will lower rates for a third time in 2019 later this year, perhaps in December.
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?
Arone: Never say never, but the likelihood that U.S. rates go to zero or even negative is very low. Conditions would have to worsen materially for that to happen. Taking a simple average of the first two quarters’ U.S. GDP figures indicates the economy is growing by about 2.6%. The unemployment rate is at a 50-year low. Several inflation measures are hovering near the 2% target. U.S. stocks reached all-time highs on July 26. This backdrop hardly suggests the U.S. economy is hurdling toward collapse.
Hill: It’s certainly possible, though that would be rather extreme. I don’t anticipate the Fed to push overnight rates negative. Rather, we’d anticipate another QE [quantitative easing] program if/when the Fed has to return the target range to the effective lower bound. In that world, we’d just expect a very low and flat curve, and 10-year yields possibly below 1% depending on the macro backdrop. While far from my base case, it is something investors would be wise to consider as a low-likelihood adverse scenario.
ETF.com: Where do you see the 10-year Treasury going in the short term and long term?
Hill: In the short term, we expect the market to stabilize in this new range, i.e., in the mid 1%’s. This will persist until there’s guidance as to whether the attempted midcycle cuts avert a recession. If so, look for 10s [10-year Treasury] to push back toward the 2-2.5% range. If not, and the economic backdrop continues to deteriorate amid the trade war, we’d expect another leg lower from here and possibly setting new all-time low yields.
Arone: In the short term, 10-year Treasury yields have fallen too far and too fast. I expect that as market volatility wanes, trade tensions cool and global central banks ease, 10-year Treasury yields will rise closer to the 2% threshold versus falling precipitously. Prospects for economic growth and inflation are not nearly as dire as what’s currently reflected in 10-year Treasury yields.
That said, it’s hard to make the case for higher long-term rates. Both cyclical and structural forces are combining to keep a lid on the long-term outlook for 10-year Treasury yields. Below-trend economic growth rates, benign inflation and negative term premium from wildly aggressive monetary policies will continue to dampen yields.
ETF.com: In this environment of plunging Treasury yields and uncertainty about the global economy, how do corporate bonds fare?
Arone: Despite recent market turmoil, credit spreads have behaved reasonably, widening only modestly. The economy is still expanding, albeit at a slower rate versus last year, and corporate profits are still growing incrementally. As a result, default rates for corporate bonds should remain low.
However, the compensation that investors are receiving for taking on interest rate risk (duration) and/or credit risk is quite low compared to historical levels, especially this late in the credit cycle. Maintaining existing allocations to corporate bonds make sense, but investors should look for opportunities to upgrade credit quality and shorten duration.
Hill: The negative growth shock out of the trade war should, at face value, be credit negative and push spreads wider. We would also expect widespread outflows as investors de-risk. We’re also attentive to the huge amount of BBB-rated credit that could be at risk of falling out of an investment-grade classification.
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?
Hill: Treasuries continue to act as a natural hedge against macroeconomic risk. With expectations of additional Fed cuts looking to try to boost forward inflation expectations, TIPS look attractive despite very low (but still positive for now) real yields. As for other determinations, it would depend on the investors’ risk tolerance and investment horizon.
Arone: Investors should recognize that the risk/return dynamics for fixed income investments are skewed to the downside. The compensation that investors are receiving for interest rate risk (duration) and credit risk are 30-50% below long-term historical averages. Investors aren’t being rewarded for duration or credit risk right now.
However, the U.S. economy isn’t likely to enter recession anytime soon, and corporate profitability is still healthy. So, maintaining existing positions in corporate bonds and below-investment-grade investments may be prudent.
Yet when adding capital to fixed income allocations, I suggest a barbell approach; for example, adding to long-term and intermediate Treasuries with the SPDR Portfolio Long Term Treasury ETF (SPTL) and the SPDR Bloomberg Barclays Intermediate Term Treasury ETF (ITE) as a hedge against equity risk and microbursts of volatility, especially this late in the credit cycle.
Balance those allocations with investments—such as the SPDR Portfolio Short Term Corporate Bond ETF (SPSB), the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB) and the SPDR DoubleLine Short Duration Total Return Tactical ETF (STOT)—that enable the investor to move up in credit quality and shorten duration while still maintaining a competitive yield. This compensation more appropriately balances the risk/reward trade-off for fixed income investments.
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