October 17, 2017

Can Long Term Interest Rates Drop Any Lower?

federal-reserveBy: Axel Merk and Yuan Fang, Merk Investments

The concern over rising interest rates has become a primary issue with investors. While few assets are immuneto rising rates the bond market may be particularly vulnerable. The headwinds may be exacerbated by changing fundamentals in the U.S. bond market, specifically growing concentration, extended duration and changing correlations posing a greater challenge for investors to manage their duration risk.

More concerning to investors may be that that, as we will show, the benefits of bonds as portfolio diversifiers may have eroded. Is the bond market at a turning point? How should one invest in a rising rate environment? Our analysis suggests that in addition to active risk management within a fixed income allocation, building a more diversified portfolio with the inclusion of alternative assets may provide investors with an improved risk-return trade-off heading into a period of rising interest rates.

The end of the 30-year bond bull market?
As the year comes to an end, 2013 has left the U.S. fixed income market scarred. In contrast with the stock market’s repeated new highs, the U.S. bond market as measured by the widely followed Barclays U.S. Aggregate Bond Index, has posted its first negative calendar year return since 2000; only the third negative year in the
index’s 37-year history. Along with the lagging performance the U.S. bond market has experienced rising volatility and a shift in investor sentiment.

Speculation of the Fed winding down its quantitative easing (QE) program and fear of rising short-term interest rates has dominated the bond market in 2013. More profoundly, it seems investors are increasingly moving to the consensus that the U.S. fixed income market may be approaching a key turning point: the end of a 30-year secular interest rate decline which started at the height of the Volcker-era tight-money policy and which was fueled by recent extraordinary monetary easing.

Down the road, pervasive market expectations of higher interest rates could put continuous pressure on bond prices. Adding to the risk, current bonds yields are near historical lows and seemingly have nowhere to go but up.

The total return on bonds is the combination of income and price movement. In previous periods when interest rates rose relatively high coupon payments often provided an effective buffer to the total return on bonds. Now, however, with yields near record lows, the income bonds generate may not be sufficient to offset the loss from
price decline due to rising interest rates, resulting in a loss in total returns.

In addition to the rising rates expectation, adding to the bond market risk is the Fed’s lack of effective communication on policy path, uncertainty surrounding the U.S. fiscal impasse and rapidly growing U.S. long-term debt. Moreover, inflation risk may materialize sooner than the market expects but has not yet been priced in.

See full article here.

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