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Have We Seen the Bottom for Interest Rates?

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RANDY FREDERICK: Hello, and welcome to the Schwab Market Snapshot for July 19. I’m Randy Frederick.

Well, over the past two weeks bond yields have rebounded sharply from the post-Brexit record lows. So, today, I’m speaking with Kathy Jones, Schwab’s chief fixed income strategist, to get her perspective on whether or not there’s any merit to some of the rumors we’ve been hearing that the bull market in bonds is coming to an end. Welcome back, Kathy.

KATHY JONES: Thanks for having me, Randy.

RANDY: So, Kathy, it does seem like the drop in rates that we saw right after the surprise Brexit referendum was a bit of an overshoot. So from your perspective, have we seen the bottom in yields yet?

KATHY: Well, it’s certainly possible that on July 8 when 10-year Treasury yields hit 1.36% that that was the generational low—but I still think it’s too early to know for sure. Based solely on U.S. economic data you would say that rates should be higher, but there’s still a lot of forces outside the United States that are keeping rates low. For example, interest rates in Europe are at zero or near zero, even into negative territory for 10-year bond yields. While in the U.S. at 112, they’re considerably higher. So still too early to say for sure.

RANDY: So let’s shift gears a moment to the Fed. Now, I know that there are still four Fed meetings in 2016. But it’s been really surprising how fast the futures market has gone from expecting really no interest rate hikes this year, to a pretty good chance now for the December meeting.

How is it possible that this probability went from a very low number to more than double that in just the past couple of weeks?

KATHY: It’s amazing how fast expectations shifted. Right after the Brexit vote the probability implied by the fed funds futures market was less than 10%—and then it jumped within a week to over 40%—and that really was on the back of, I think, two things.

One is the realization that Brexit is a long-term event. It’s not a short-term event. It’s not going to have an immediate impact on the world economy. And, secondly, we had a string of good economic numbers in the U.S. that suggested that, yes, maybe the Fed will raise rates by the end of the year.

RANDY: So it sounds like interest rates are still going to be low for quite a while. Besides the Brexit, what other factors are there out there right now that are weighing so heavily on yields?

KATHY: Well, slow global growth is one of them. I like to monitor global trade flows as a way of assessing how fast or slow the global economy is growing. And right now, volume of trade is running at about half its historical pace.

That tells me we’re still in a slow-growth mode. But then, there’s also the supply-demand dynamics that are driven by central bank bond buying. So, right now, the major central banks have taken a lot of the supply of bonds off the market.

The Federal Reserve holds about 15% of the outstanding U.S. Treasuries on its balance sheet—and that’s been stable for a couple of years. The European Central Bank has been ramping up its bond buying, and holds about 8% of government bonds on its balance sheet—and that’s likely to grow. And then the Bank of Japan, which has been buying bonds for quite some time, owns over a third of Japanese government bonds on its balance sheet.

So a lot of the supply has been taken out of the market, while at the same time demand continues to grow because we have aging populations in most major developed countries. And as people age, they tend to save more and they tend to look for investments that provide income. So there’s more demand for bonds at the same time that the supply is getting constrained by the central banks.

RANDY: So there’s clearly a lot of factors weighing on this. So in this environment I know many investors will want to probably try to insulate themselves from some of the volatility. And one way to do that is to probably do a thorough review of their bond portfolio. What is the best way for an investor to do that?

KATHY: Well, you can try yourself, but it might be easier to contact your financial consultant and they can put you in touch with a regional bond specialist. And what a regional bond specialist can do is use our fixed income analysis—portfolio analysis tool—to assess what you’re holding in your bond portfolio.

And that will give you a sense of the sensitivity of your portfolio to interest rate changes by looking at the duration; the credit risk, meaning how exposed are you to the ups and does of the business cycle; and then the cash flows that you could be expecting from your portfolio.

And then you can take that information and make sure that it matches up with what’s in your overall financial plan. So it’s kind of the easiest way to integrate your bond portfolio with the rest of your financial plan with your consultant.

RANDY: That sounds like really good advice, Kathy. Thank you for sharing your expertise on these topics.

That’s about all the time that we have. If you want to read more from Kathy, you can do that in the Fixed Income and the Insights and Ideas section of Schwab.com.

And you can always follow Kathy on Twitter @KathyJones, and of course you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.

Important Disclosures

Please note that this content was created as of the specific date indicated and reflects the authors’ views as of that date. It will be kept solely for historical purposes, and the authors’ opinions may change, without notice, in reaction to shifting economic, business, and other conditions. The information presented does not consider your particular investment objectives or financial situation (including taxes), and does not make personalized recommendations. Supporting documentation for any claims or statistical information is available upon request.

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.

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

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The detailed fixed income portfolio report is for informational purposes only and not intended to be used as the sole basis for investment decisions. It is not a recommendation to buy, hold, or sell any specific securities or to engage in any specific strategies.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

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