What Does Fiscal Stimulus Mean for Bond Investors? | Charles Schwab

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What Does Fiscal Stimulus Mean for Bond Investors?

February 17, 2017

Just last summer, bond investors were worried about negative interest rates landing on U.S. shores. Those concerns were largely due to the subzero-interest-rate policies adopted by five major overseas central banks. If they could lower rates below zero, could the Federal Reserve be next?

What a difference a few months make. Global bond markets have undergone a major shift, mainly in response to two somewhat surprising outcomes—the Brexit vote in the United Kingdom and the election of Donald Trump in the United States—which together have all but wiped out concerns about negative interest rates here at home.

These elections suggest an increasingly populist sentiment around the globe—and with it a different approach to economic stimulus. Instead of reliance on monetary policy, which lowers interest rates to stoke the economy, we expect an embrace of fiscal stimulus, which uses tax cuts and increased government spending to fuel expansion. This shift could be a game changer for the world’s bond investors, who may finally receive the higher yields they’ve been craving.

Let’s take a closer look at how fiscal stimulus, inflation and a rising dollar might impact bond investors.

Fiscal stimulus

Likely impact: U.S. bond prices down, yields ­up

Since the Great Recession, central banks around the world have pushed interest rates to record lows to stimulate borrowing and economic activity. But these rock-bottom and even negative interest rates haven’t done much to spark global economies, and have been hard on savers, especially retirees. Insurance companies and pension funds, which invest for income over the long run, have also struggled in this protracted low-rate environment, as have banks, for which lending has been far less profitable.

Even before last year’s elections, several governments had started loosening their purse strings to stimulate their economies, rather than relying almost exclusively on low interest rates. Rising expectations that governments may further shift away from monetary policy in favor of other fiscal measures1 have already done much to lift bond markets worldwide (see “Bonds step up,” below).



Inflation

Likely impact: U.S. bond prices down, yields ­up

More fiscal stimulus means more money pouring into the global economy, which should stimulate demand and drive up the cost of goods and services. Where bonds are concerned, fiscal stimulus means governments will finance more debt, creating a greater supply of higher-yielding bonds and further driving down prices on existing ones. What’s more, inflation and a widening budget deficit mean the Fed is likely to raise interest rates more rapidly than previously anticipated, further pushing up yields on new bonds while making existing bonds even less attractive.

One caveat: A strengthening U.S. dollar (see below) could cause the Fed to slow its pace of tightening. That’s because the effect of a rising dollar is similar to that of a Fed rate hike: It makes U.S. exports more expensive on world markets, reducing exports and slowing economic growth. Meanwhile, a stronger dollar lowers import prices, reducing inflation. Consequently, a significant rise in the dollar could conceivably waylay future rate hikes.

A rising dollar

Likely impact: International bond prices down, yields ­up

In the U.S., there are signs that the dollar’s rise will continue. U.S. short-term interest rates are already significantly above those in Europe and Japan, and the likelihood of even higher rates as the U.S. economy continues to outpace other major markets could make the dollar even more attractive relative to other major currencies. Combined, these forces could help extend the dollar’s rally, with negative consequences for many non-dollar-denominated bonds. 





What you can do

With the U.S. economy growing, inflation edging higher and the prospect of fiscal stimulus on the horizon, bond yields are likely to continue moving higher in the short term. That’s a mixed blessing for investors. On the one hand, higher interest rates will push down the price of bonds. On the other, higher yields will come as welcome relief to investors who’ve been waiting years for the increased income from their portfolios.

In general, investors can best prepare for moderately higher interest rates in the year ahead by:

  • Reducing the average duration of bond portfolios: Buying bonds with shorter maturities can help you take advantage of rising rates sooner. A bond ladder—in which you purchase individual bonds with staggered maturity dates and reinvest the principal in new bonds as each one comes due—is one way to accomplish this.
  • Reducing exposure to foreign bonds: Foreign bonds generally have lower yields than those in the U.S., and the value of those priced in their local currency may continue to slide in the face of a strengthening dollar.

That said, the continued rise of the greenback could slow the pace at which the Fed raises interest rates, making the strategies above less urgent.

Kathy Jones (@kathyjones) is senior vice president and chief fixed income strategist at the Schwab Center for Financial Research.

1John Geddie and Dhara Ranasinghe, “Bond index slide is latest sign debt’s long rally is ending,” Reuters, 11/18/2016.


Important Disclosures

Past performance is no guarantee of future results and the opinions presented here cannot be viewed as an indicator of future performance.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.




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