Globally, interest rates have declined over the past 30 years in a bull market for bonds. In the United States, the 10-year treasury was yielding close to 8% in early 1990, compared to today’s yield of 0.80%. European government bond yields have moved in a similar trajectory. Ten-year German bunds were yielding over 9% in 1990 compared to -0.57% today. As interest rates decline, the price of the security increases, thereby generating a positive total return and satisfied bond investors for three decades. However, how much lower can yields go? And, what has caused this dramatic decline to where currently there is close to $11 trillion in debt globally with negative yields?
In the 1990’s there were several shocks that resulted in central banks lowering interest rates, followed by the dot-com bubble in the early 2000’s and the financial crisis in 2008-2009. During the financial crisis, central banks experimented with 0% target rates in addition to opening-up their balance sheets to asset purchases. These purchases included government bonds and government agency mortgage securities. These target asset purchases provided an artificial yield ceiling. Many of these same techniques have been revived as part the COVID-19 support programs.
The COVID-19 pandemic has resulted in a dramatic slowdown in economic activity. Global central banks in advanced economies have taken unprecedented actions to add stimulus to the global economies in the COVID-19 pandemic. In less than a year, there have been over 200 central bank rate cuts around the world. As the chart illustrates, global short rates have been cut in half from their already low historical levels. For example, yields on 2-year German bunds are currently -0.63%, 2-year Swiss bonds are yielding -0.73%. In the US, although yields are low, they are not negative. The 2-year US Treasury is yielding 0.21%.
Source: Evercore ISI
In the US, the Federal Open Market Committee (FOMC) reduced the federal funds to a range of 0.00% to 0.25% and implemented a slew of credit and lending programs that could inject more than $6 trillion in the economy. This is in addition to the $4 trillion and counting in fiscal measures that have been enacted by the federal government. The European Central Bank (ECB) announced a $672 billion expansion to its Pandemic Emergency Purchase Programme (PEPP), bringing its total bond buying effort to $1.53 trillion. These bond-buying programs have increased their combined balance sheets from $9 trillion to $13 trillion.
Source: Evercore ISI
Bond investors have reaped the benefits of declining interest rates by generating a positive total return (of varying size depending upon duration and security type), but investors are facing lower absolute returns in this current environment. Low interest rates disadvantage savers and force some investors to reach for yield in lower rated or longer maturity bonds.
A positive effect from the various Fed moves is the re-steepening of the yield curve as measured by the yield differential between the 2-year US treasury note and 10-year US treasury bond, which is now 0.60%, but is lower than the 10 year average of 1.32%. A positive sloping curve has historically been associated with improving economic activity. This measure was -0.05% in August of 2019.
Corporations have also taken advantage of the government support and have issued debt at a record pace. Since credit spreads hit their peak on March 23, a total of $750 billion has been issued, bringing the year to date total to $1.09 trillion. This compares to a total of $1.1 trillion for all of 2019.
FOMC Chairman Powell indicated this week that the fed is in no rush to increase interest rates and will maintain the 0% rate at least through 2022. A side effect of all this intervention could be increasing future inflation when the economies return to health. This is a concern that we will be monitoring for potential portfolio adjustments. An increase in inflation may erode the purchasing power of bonds and lead to an increase in yields. Until that time comes, this low interest rate environment is likely to remain in place.