Low Interest Rates Abound Globally

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While the Federal Reserve raised overnight interest rates in mid-June, the intermediate and longer treasury maturities declined, leading to a flatter yield curve (the yield differential between long term and short term rates declined).  What is most interesting is the yield curve is shaped very similarly to the curve on June 30, 2016, following the Brexit vote but steepened by year end following the presidential election and market participants becoming optimistic about growth and potential inflation. 

Treasury Yield Curve

There are two primary reasons for the movement to lower long-term yields during the last quarter.  The first is the lack of wage growth and inflation in the market, leading to a lower inflation premium demanded by market participants.  The second reason is the global interest rate environment, especially in Japan and Europe.  Yields on 10 year U.S. treasury securities at the time of this writing are 1.88% and 2.09% higher than Germany and Japan, respectively.  There is incentive for foreign buyers to continue to purchase and hold treasuries until the ECB begins to remove quantitative easing and foreign interest rates begin to rise.

Prior to the last month, the 10 year treasury had been trading in a range of 2.30% to 2.60% but the lack of wage growth, expectations for continued slow growth and lower inflation numbers moved the yield lower and outside the range.  The Consumer Price Index stood at 1.9% year over year in May with Core CPI (ex Food and Energy) at 1.7% year over year.,  At current interest rate levels, the after inflation interest rate on 10 year treasuries is less than 0.50%.  Looking at it from this perspective, the market is anticipating lower inflation over the next 10 years than historical averages.  While this may hold true, we do not believe that inflation will decline dramatically from this level during the next 12 months and may put some upward pressure on intermediate and long term rates.

Similar to the first quarter of 2017, spreads (the difference in yield between the corporate issue and a similar maturity treasury) continued to tighten, providing favorable returns as illustrated in the following chart.  High yield and emerging market bonds provided positive returns.  While spreads are at or below long-term averages, we continue to believe there is added value in these securities in a flat to upward interest rate environment.  With the slow economic growth environment, we do not see a recession on the immediate horizon, which ultimately would lead spreads higher and provide less incentive to be invested in these securities.

Bond Asset Class Performance Year To Date

Municipals became very cheap relative to taxable bonds following the presidential election due to fears of lower tax rates and less value in these securities. Tax reform is still on the agenda but municipal yields have declined during the first half of the year, leading to strong returns.  While municipals have declined in yield, investors in the higher marginal tax brackets can still realize an advantage by participating in this market.

With continued slow economic growth and a potential recession further out on the horizon, we believe intermediate and long-term interest rates are near the bottom of the range.  On the fixed income side, we continue to maintain a slightly shorter average maturity than the target benchmark maturity and are focusing on spread product such as corporates, high yield and emerging markets.  We realize the added value from these investments will come from the higher yield rather than continued spread compression but in a flat to rising interest rate environment, additional income protects portfolios.

Betsy PiersonElizabeth S. Pierson, CFA is a Senior Vice President & Chief Investment Officer with Alpine Trust & Investment Group.

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