Low Rates? Get Used to It
I have been fairly agnostic on several issues related to where interest rates are heading. It has never been my job to forecast where the 10-year yield will be in six months. Not predicting and not caring are two very different things, however. Rates matter a great deal -- to investors, to the economy and most of all to debtors of every kind.
You would be hard-pressed to find anyone in finance who would ever admit to believing that rates don’t matter. Despite the importance of bond yields and borrowing costs, few seem to have any idea how to analyze them in a way that provides a helpful conclusion.
And while many are quick to point out how disruptive the Federal Reserve programs of quantitative easing and zero-interest rates have been to stock and bond prices, that's a terrible excuse. One would think that something so big, so contentious and so transparent would be easy to insert into traditional economic models. But no.
As it turns out, most of the economic community on Wall Street has gotten this terribly wrong. Some have disagreed, such as Jeff Gundlach and Gary Shilling (see this and this) but they are notable exceptions.
There are many indicators that keep suggesting that our low, low, low rate world is going to stay this way for a long time. Some of these are turning out to be more significant than many had expected.
First, the broad consensus about bonds has proven to be wrong, at least so far. It was startling to see literally all of the economists surveyed in early 2014 agree that rates were going up, which of course would hurt bond prices. (See "Nobody Likes Bonds!" and "The Consensus Hates Bonds.") That was an early sign that something was amiss. As the great Bob Farrell stated in his 10 rules for investing, “When all the experts and forecasts agree — something else is going to happen.”
Contrarians who took notice of the uniformity of agreement profited handsomely last year, as bonds were a top-performing asset class.
Second, rates around the world have been low, and appear to be going lower. Japan’s 10-year bond yields just 0.37 percent, while comparable German bonds yield even less at 0.21 percent. Then there is Switzerland, where the 10-year yield is negative; the country charges 0.067 percent for the privilege of borrowing money from investors. Forget zero bound, we are wandering in the wilderness, strangers in a strange land of negative sovereign rates.
Perhaps it was overdue, with U.S. Treasury buyers playing catch up (or catch down) to the rest of the world. Looking at 10-year bond yields for 20 developed nations last June, I was astonished to see the U.S. ranked 16th in yield. That was on par with countries such as Spain! Today, U.S. 10-year Treasuries yield 1.98 percent -- a spectacular bargain for fixed-income investors compared with German and Japanese debt.
Third, and perhaps most telling of all, is the “Great Global Sovereign Bond Shortage” of A-rated paper. There is no deficit of junk paper around the world, but that isn't what institutions, endowments and foundations demand. They insist upon quality debt issues, often as required in their very charters. That, plus a variety of other factors, has created a shortage of quality sovereign securities. As we noted before, the key word is quality. There's all the garbage paper you want, but a very limited supply of good paper.
And there is no apparent end to the demand. The U.S. passed the QE baton to Japan, with the European Central Bank ready to handle the next leg of the relay race. Central banks around the world have certainly contributed to the demand, but it has clearly been more than just them.
Perhaps the biggest quandary related to these ultralow rates is why nations that run budget deficits are not taking greater advantage of them. Look no further than the USofA for a country with enormous financing needs and none of the political will to admit the simple truth.
I can think of 18,152,362,814,977 reasons for the U.S. to issue a 50-year bond to refinance all of its debt. This will become even more important if and when China ever begins to reduce its purchases of U.S. Treasuries. There are some early and anecdotal signs that it may have started doing so. It is only prudent to have an independent financing plan rather than being dependent on the kindness of strangers.
Interest rates will rise one day. So far, those who have been predicting a return to traditional rate environment have been dead wrong. Are they just early, or is this a paradigm shift? We may not know for some time.
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