For at least the past two years there has been widespread expectation in the financial community that long-term benchmark U.S. Treasury yields will rise. Behind this thinking: The conclusion of the Federal Reserve’s extraordinarily accommodative monetary policy (which included three rounds of quantitative easing) combined with general improvement in the U.S. domestic economy would soften demand for Treasury bonds and require investors to demand an inflation premium to compensate for healthier economic growth. We have seen several short periods of yield increases during this time frame but those trends were not sustained long enough for the real yield (nominal yield minus the level of inflation) to reach its historical normal level of roughly 2.00%. Although there are numerous factors that impact the level of benchmark long-term government bond yields, we want to highlight with this commentary a relatively recent issue that has come into play.
The chart below shows current 10 year benchmark government bond yields for a number of sovereign debt issuers around the globe. From a historical perspective, the current yield on 10 year U.S. Treasury bonds is low in both nominal and real terms, but, compared with other available bonds, the current level of U.S. yield is attractive for global investors – especially taking credit quality into consideration. Of course, these yields move continuously with changing capital flows and economic fundamentals but the difference today represents abnormally wide levels for top quality debt issuers. In part this is a reflection of the divergent monetary policy actions now in play. It is also an indication that several overseas regions – particularly Europe and Japan – are still dealing with concerns about deflation taking hold. Whatever the reasons behind current yield levels, one fact stands out: U.S. Treasury debt is actually attractive for a global investor.
For the record, we do believe the next major trend in the bond market will be higher benchmark U.S. Treasury yields, but because of the current level of global alternative yields highlighted above, that path may be longer and more uneven than originally anticipated.
Yesterday in Washington, the U.S. Federal Reserve began an Open Market Policy Committee meeting, with a policy announcement and press conference scheduled for this afternoon. It is expected that the Fed will continue to offer market participants clues as to their intention with short-term benchmark interest rates. At present there are expectations (depending on the strength of domestic economic data) that sometime between June and December the Federal Reserve will increase short-term benchmark rates for the first time since 2006. Perhaps this action will be the catalyst to finally nudge long-term rates higher. If not, it might very well be partly the result of the opportunity set available to global bond investors highlighted above.
Overall, we have positioned fixed income portfolio allocations to be less sensitive to rising long-term interest rates. However, we continue to look for opportunistic investments to enhance portfolio income and overall total return potential within the asset class. Because of our relatively short duration investments, when long-term bond yields do rise we will be in a good position to take advantage of them. That said, because of the dearth of high quality global alternatives available to bond investors, that opportunity may take a little longer to arrive than expected.
Jack E. Payne, CFA, CFP
Chief Investment Officer