The Federal Reserve’s desire to raise short-term interest rates has been clearly communicated for many months. It has been the key issue driving the investing markets all year (at least until last week's Brexit vote), and a huge amount of effort has been expended by pundits of all stripes trying to determine how many hikes are likely and when they are likely to occur.

In December 2015, the first interest rate hike in nine years finally arrived. The Fed had been talking about raising rates for so long at that point that many felt they would lose credibility if the year ended without at least one hike. This increase boosted the shortest-term interest rate from essentially zero to 0.25%. The year ended with the Fed communicating their intent to raise rates four more times in 2016.

As has frequently been the case, however, the Fed’s plans haven’t coincided with the economic facts on the ground. The sluggishness of the global economy has kept the Fed from executing any further increases in 2016, despite interest rates being at historically low levels. With economic growth so tepid already, they clearly don’t want to add a headwind that could tip the economy over into recession.

It’s widely believed that the Fed’s primary motivation for wanting to raise rates now is to give themselves the ability to cut them again during the next recession. Rate cuts are the primary tool the Fed has to try to stimulate the economy. But its ability to stimulate during a recession is hampered if interest rates are already near zero. Thus their desire to push rates higher now, ahead of any recessionary signs.

Unfortunately, if rate cuts are considered to be stimulative for the economy, the opposite is also true — rate hikes present a drag on the economy, at least in normal conditions.

The bond market’s message is clear

What many people fail to realize is that while the Fed controls the shortest-term interest rates, supply and demand within the bond market set interest rates for longer-term debt. Because of this, it’s not terribly unusual for the bond market to signal its disagreement with the Fed’s agenda.

That has been the case lately, as evidenced by the yield-curve chart below. It shows what interest rates were at each step of the yield curve in June 2015 (in gray) compared to where rates for those same maturities stand today (in black). While rates are indeed 0.25% higher at the very short-end (which the Fed controls), it’s obvious that the bond market has been speaking — loudly — that interest rates should currently be falling rather than rising.


(Click chart to enlarge)

This is inconvenient for the Fed, given their perceived desire for rates to increase. But it makes sense in light of the two primary causes for the decline in longer-term rates over the past year.

  1. Interest rates move in response to expectations for economic growth. Lower economic growth decreases the likelihood of inflation, which is the nemesis of bond investors. Lower growth also makes Fed hikes (which would put upward pressure on longer-term interest rates) less likely. So, as the economic news has gotten worse this year, bond investors felt increasingly safe investing in bonds, pushing bond prices higher. Because bond yields move in the opposite direction of bond prices, yields have declined.
     
  2. Negative interest rates in Europe and Japan have helped pull U.S. rates lower. Interest rates on bonds aren’t set in a vacuum — they’re always fluctuating in relation to competing alternatives. When other countries cut their interest rates, the higher yields of U.S. bonds become more attractive. This causes foreign investors to buy our bonds, which pushes U.S. bond prices up and yields down. Given that much of Europe’s and Japan’s debt has moved into negative-yield territory, it would appear there’s still quite a bit of room for U.S. rates to fall while continuing to look attractive by comparison.

Implications for investors

For the past several years, bond investors have been forced to hold two conflicting realities in their minds. The first is that, from a big-picture standpoint, what’s been happening in the bond markets is madness. It’s extremely likely that someday investors will look back at this period in astonishment, wondering who thought it was a good idea to lend money to the world’s governments and actually pay them for the privilege. That’s exactly what’s happening with negative interest rates in Europe and Japan currently, and the U.S. isn’t far behind. Government debt is being priced as if it carries zero risk, which given the state of the developed world’s finances and rapidly approaching demographic realities, couldn’t be further from the case.

Recently a chart made the rounds showing that global interest rates today are at the lowest point in the recorded history of human civilization. As we frequently remind SMI investors, when bond rates move in one direction, their prices have to move in the opposite direction. So another way of stating that interest rates are at all-time lows is to say that bond prices are at all-time highs. Eventually, this will reverse and fixed-income investors will suffer either outright losses or very low returns, depending on the types of bonds they hold.

While that long-term view of the bond market is obviously scary, the problem is that it has been evident now for several years. Despite this, the trend for bond yields has continued lower still — largely due to central banks taking unprecedented actions to support these ever lower rates in the hopes that they will spur economic growth and the coveted inflation that will allow them to repay their debts with cheaper currency.

With no sign of improvement in the global economic condition, it’s difficult to envision this trend changing anytime soon. So in the short-term, conditions continue to favor bond investors. Someday the bond market will be a potentially painful place to be. But there’s no indication that day is close at hand.

SMI Bond Upgrading

This “short-term-positive, long-term-negative” outlook for bonds is what caused us to completely reconfigure our bond selection process last year. We want to continue to own bonds as long as they remain profitable. But we also need a mechanism to signal when it’s time to pivot back to safety when bond yields eventually do start moving higher. We believe our Bond Upgrading strategy provides for both of these needs.

Eventually, interest rates are going to adjust higher — and bond prices will adjust lower. But watching Japan maintain ultra-low interest rates for decades now has proven that exceptionally low interest rates can persist much longer than anyone expects. By most indications, not only are higher U.S. interest rates not imminent, they may yet have further to fall. That’s bad news for savers, who continue to starve for yields. But it’s good reason for investors to stick with their current bond allocations until SMI’s mechanical Bond Upgrading (and Dynamic Asset Allocation) signals say it’s time to depart.