Wednesday, July 09, 2014

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Joe: In general, because inflation erodes the purchasing power of their returns, investors demand an inflation premium for all bonds and fixed income securities.  For U.S. Treasuries, that premium has varied from around 1% for short maturities to nearly 3% for longer maturities.  Investors have also demanded a rate of return in addition to the inflation premium.  We call that second layer of interest rates the “real” rate of return.  You can see this layering effect on the chart below, which compares the interest rate on a 10-year to the level of inflation going back to 1995.

As the chart above shows, the 10-year U.S. Treasury rate (blue line) typically stays above the inflation rate (red line).  The difference or “spread” between the two lines represents the real rate of return to investors.

Over the past 50 years, inflation has averaged just over 3% and investors in 10-year U.S. Treasury bonds have demanded about a 2.5% percent real rate of return.  Thus, 10-year U.S. Treasury bonds have averaged about 5.5% during this time.  The problem for investors is that these long-term relationships are not highly correlated, meaning both the inflation premium and the real rate of return in any given market can vary widely.  Since 1960, 10-year Treasury bond yields have been as much as 9.5% above the rate of inflation and 5% below.  Today, 10-year U.S. Treasury bonds are yielding about 2.5% and inflation is running at about 1.5%; thus, investors are only receiving a real rate of return of 1%.    

Nathan:  Why do you think investors are willing to accept such a low real rate of return?

Joe: The answer to that question can be answered in five words: slow-growth economy and Quantitative Easing. Because of the slow-growth economy, the Federal Reserve has purchased billions of dollars worth of 10 and 30-year Treasury bonds to push rates lower in order to stimulate the economy. In reality, because there is a desire for safe bonds, the Fed is forcing investors to buy an artificially low yield. For this reason, we do not consider U.S. Treasury bonds a good investment. We believe rates on U.S. Treasuries will rise gradually over the next few years. Referring back to the teeter-totter effect, that would mean that bond prices are headed downward.

Nathan: The economy has been in a slow growth environment for some time now.  If the economy begins to grow more quickly, what would be the impact on inflation and interest rates?  

Greg: That seems like a simple question, but that “if” word confuses matters dramatically.  The Federal Reserve has done everything in its power to stimulate growth and yet GDP growth has been anemic.  We are experiencing the slowest economic growth since the Great Depression of the 1930s, and we don’t think things are going to change very much in the near term.  In our judgment, until the housing industry recovers closer to its historic growth rates, the economy will stay in low gear.  Housing has a much bigger impact on the overall economy than the economic data show.  Having said that, in a faster growing economy, there is no doubt that interest rates would rise.  Surprisingly, however, we don’t believe inflation is likely to rise much in the coming years and that would mean that interest rates will stay lower than most people may now think.  The Fed knows how to control inflation, and we have no doubt they will not let it get out of control.  The Fed’s current target for inflation is in the range of 2-2.5%.  They will probably let it slide a little higher than that for a while, but not enough to cause the bond market to become panicked and send interest rates soaring.  

Nathan: Greg, as you said earlier, the Fed has effectively targeted interest rates since 2008 and in doing so through the Quantitative Easing program has amassed a balance sheet totalling more than four trillion dollars.  Isn’t the bond market at great risk as the Fed begins to unwind this huge portfolio?

Greg: The Fed did not go to all the trouble and expense to amass these bonds to throw them back on the market and undo all the good they believe the program has achieved.  Most people don’t realize that the Fed is under no mandate to unwind the portfolio.  In fact, both recent Fed Chairs, Ben Bernanke and Janet Yellen, have said they may allow the portfolio roll off by holding the assets to their stated maturity dates.  If that is the case, the impact on interest rates would be muted.

Nathan: What is DCM’s current opinion on inflation and interest rates over the next 12 months?

Joe: We expect a short-term uptick in inflation as the economy recovers from the very cold winter, but don’t believe it will stick.  We expect inflation will stay in the 1.5% to 2% range for most of the year.  The main reason we don’t believe inflation can return in any meaningful way is because wage growth remains well contained.  Since the 2008-09 subprime crisis, private employee wage growth has averaged about 2% per year.  Unless that were to push above 3% and stay there for a time, we are optimistic that inflation will remain tamed.  Wage growth is being held back by the relatively high unemployment rate, but also by the more than five million people who have stopped looking for work and are no longer in the unemployment statistics. We’re not seeing much in terms of wage growth at the moment.  The good news here is job growth, while muted, has been steadily increasing over the last nine months, except for the weather-impacted data in February.

Our 12 month forecast for interest rates is that the Fed will keep short-term interest rates about where they are.  If economic growth starts to pick up, we could see the longer-term interest rates start to move higher.  In this scenario, we would expect the 10-year U.S. Treasury to peak around the 3.5% area and only push higher from there once the Fed signals an increase in short-term rates.  Even then, we do not see 10-year bonds moving back to their long-term average yield of 5.5% for many years.  There remains too much slack in the economy to cause that to happen.

Next Time: How and Why We Emphasize Preferred Stocks in Fixed Income Portfolios