KATHY JONES: The recent bout of market volatility has left a lot of investors concerned about their portfolios and also uncertain about what’s behind the big rise in bond yields recently. I’m Kathy Jones, and, today, we’re kicking off Schwab Bond Market Today, our new biweekly report on the fixed income markets.
Let’s start with that recent rise in interest rates. Since last fall, 10-year treasury yields have risen about 80 basis points from about 2% to about 2.8%. That’s a pretty big increase in a short period of time. We think there are three reasons behind this.
First, inflation expectations are up, and that’s driven by stronger economic growth and the fall in the unemployment rate which is lifting wages. So the combination should push up demand, which can result in higher prices. Also, the dollar is down, and when the dollar falls that tends to push up import prices, and that makes its way into inflation, as well.
A second reason is the prospect of higher budget deficits going forward. Recent legislation suggests that the deficit will rise to about 5% of GDP over the next couple of years. That’s nearly double where we’ve been recently, and that means the Treasury has to issue more bonds, and when they issue more bonds, somebody has to buy them, and, typically, when you increase the supply the yield goes up to find more buyers.
But the third reason is more structural, and we think a really important one to focus on. We’re coming to the end of this era of very easy money from the central banks. So over nearly a decade we’ve had the major central banks of the world buying up bonds to stimulate economic activity and hold down interest rates. Now, they’re pulling back from that. The Federal Reserve has raised rates about five times over the past year or so, and now they’re allowing the bonds on their balance sheet to roll off, and that means more supply for the market to absorb. We estimate in 2018, that will increase the amount the market needs to absorb by about 400 billion compared to a year ago, and that’s why naturally means that we’ll probably have to have yields move higher to find those buyers to replace the Federal Reserve. But, also, one of the outgrowths of quantitative easing was that it pushed down the risk premium in the markets, because when the markets knew that the central banks were there to support the economy, then it rewarded risk-taking without necessarily requiring a lot more compensation. So what we ended up with is the risk premium for holding longer-term bonds or for holding riskier bonds declined. Now we think that that will come up and that will increase volatility.
So what does it mean for investors? Well, we’re still cautious about taking too much risk in this environment because we do see yields grinding higher from here, so we wouldn’t take too much duration or credit risk at this stage of the game. But down the road, we think that an increase in that risk premium at a time when the economy is doing well and is growing at a healthy clip means that investors will probably get rewarded better for taking risk than they have been for quite some time, and we see that as an opportunity.
If you would like to learn more, please go to Schwab’s website under Insights &Ideas and get some more bond insights, or follow me on Twitter @KathyJones. Thanks for watching.