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