Interest rates have been low and falling for some time. Yet most analysts still expect them to rise—it's just a matter of when and by how much—or so they say. For our part, we continue to think rates will remain low and, in fact, are reducing our long-run forecast for the 10-year U.S. Treasury yield from 3.0% to 2.5%. However, thanks to the particulars of the current economic environment, we believe U.S. yields are likely to fluctuate in an even lower range with a central tendency of around 2.25% or less over the next several months, if not quarters or years.
The drop to ultra-low yields can be seen as a two-stage process. In stage one, the world's central banks regained control of inflation. That, combined with the aging of the baby boomers, allowed yields to fall back to the more normal low levels that existed prior to the 1970s. The drop in yields in stage one enabled a massive increase in leverage across most developed countries, which may now be depressing growth and the demand for credit, thereby decreasing the equilibrium level of yields into the ultra-low realm of stage two. Although the U.S. economy is faring reasonably well and the Federal Reserve is preparing to lift rates, we see the bond market as well braced. In fact, a higher Fed funds target rate may accelerate the rise of the U.S. dollar and depress U.S. growth. As a result, we see a hawkish Fed as more of a threat to the economy than to the bond market.
If our premise is correct and yields stay ultra low, why should investors stick with bonds?
1) Returns should continue to surprise on the upside—especially the higher-yielding sectors—thanks to the generous spreads on the non-government sectors and the benefit of rolling down the yield and spread curves.
2) Alpha from active management. Market dislocations during the ongoing transition to the new ultra-low rate environment should continue to result in significant opportunities to add value through active management.
3) Diversification. Fixed income will continue to provide ballast to portfolios relative to higher-volatility sectors, such as equities and real estate.