Just a year and a half ago, investors were worried about what a rising interest-rate environment would do to bond portfolios. After all, interest rates were already at extraordinarily low levels in many sectors of the fixed-income market, and it seemed that rates had nowhere to go but up. Rising interest rates, of course, translate into falling bond prices.
Eighteen months later, fears about rising rates are muted, Robert Tipp, managing director and chief investment strategist for Prudential Fixed Income Management, told participants at the SVIA’s 2012 Fall Forum. The outlook for the bond market remains favorable, he said, with rates for the long Treasury bond likely remaining stable in a low range of about 3 percent to 3.5 percent.
That favorable outlook is attributable in part, Tipp explained, to Federal Reserve monetary policy. In addition to disclosing that it plans to keep its target Federal Funds rate near zero percent through mid-2015, the Fed also recently embarked on a massive program to purchase additional agency-backed mortgage securities at a pace of $40 million per month, adding further pricing support to that sector of the market. That should continue to depress yields in other fixed-income sectors, he said.
Tipp outlined several other reasons why the outlook for the fixed-income markets remains stable:
Historically, Tipp said, long-term interest rates in countries with a stable monetary framework, a reasonable amount of security and a solid nstitutional framework have held near 4 percent the vast majority of the time. One reason? “When you have disasters,” he observed, “the only thing that goes up is long government bonds. They’re the only storehouse of value.”
Real estate softness.
There has been encouraging news on the housing front lately. Home prices are showing signs of stabilizing, and a growing U.S. population is expected to continue to drive household formations and hence the rental market. Still, Tipp said, there is a lot of housing inventory sitting on the sidelines while owners wait for the right time to put up for-sale signs. So while the nascent housing recovery is good for the economy, it is not a problem for the Fed’s easy monetary policy. “This is not a boom that needs to be headed off at the pass with higher rates,” Tipp said. “The Fed is thrilled to see this.”
High debt levels.
While the U.S. economy is growing at about a 2 percent annual rate, that’s hardly exorbitant. And high debt levels in both the private and public sectors will continue to dampen economic growth, easing pressure on the Fed to push interest rates higher anytime soon.
Unemployment is down significantly from its post-recession highs, at 7.9 percent in early November. But that’s still well above the Fed’s target. It could be worse than it appears, too, since many people have dropped out of the workforce and aren’t being counted among the unemployed. This argues for continued accommodative monetary policy, Tipp said, as does decelerating wage growth.
Demand for money remains modest.
Demand for money is ultimately what pushes up interest rates, Tipp said. While demand has increased since the financial crisis, he said, it remains extremely muted. “To the extent there is net demand for money from government and the private sector,” he added, “the Fed is soaking it up.”
The U.S. dollar remains strong.
While some people worry about the dollar losing value, Tipp said the U.S. currency has never been perceived as a better storehouse of value than it is now. He pointed to the strength of the U.S. Treasury market as evidence. “U.S. fixed income markets are the soundest in the world, the most coveted, safest, most liquid, broadest and deepest,” he said. “Even during the U.S. financial crisis, the value of the dollar shot up. We’re the flight-to safety currency.”
High cash reserves.
Institutions and individuals have higher levels of cash reserves as a percentage of GDP than they have at any time since 1980, except for a brief period at the height of the 2008 financial crisis, Tipp observed. That provides a strong backdrop of support for the fixed-income markets.
Institutions and individuals alike remain highly averse to risk in the wake of the financial crisis, which continues to keep them buyers of fixed-income assets. Over the next several years, Tipp said, higher-yielding spread products should be among the best performers in the fixed-income market. More broadly, he added, the Fed’s efforts to bring about better economic growth by stabilizing interest rates at low levels should be supportive of other asset classes, too. “Low discount rates on bonds,” he said, “push up valuations for stocks and real estate.”