The bond market has spent a few decades confounding most investors and their advisors, and even the Federal Reserve itself. Most participants believe that the Fed controls interest rates, which is only partially true. Most participants believe the Fed is to blame for low interest rates, which is also only partially true. Meanwhile, savers whine and advisors strain to meet income needs as rates ratchet ever lower.
Understanding why rates have spent decades declining is crucial to understanding how to deliver the best fixed income services to clients — particularly retirees living on fixed incomes. Unfortunately, not even the Fed evidences much understanding of its own markets.
Past and Present
To set the stage, we need to follow researcher Paul Schmelzing into the 1300s, as he investigates German municipal finance, annuities and rents. His paper, “Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018,” published in January 2020, shows that interest rates have been falling for, well, centuries. Spurring this decline was a gradual increase in credit quality and in more modern times, less default risk.
Of course, there were plenty of rising rate environments inside that long trend. Those of us with careers stretching into three and four decades are familiar with the inflationary experience post WWII in the U.S. But like other inflationary periods over the last several centuries, the U.S. experience was an anomaly, and a short-lived one, too. Generally, interest rates have marched ever downward while we have been in practice.
Yet practitioners as well as the media and many clients continue to behave as if, despite all the evidence, the U.S. inflationary anomaly is ever and always about to resurface and that rates cannot remain “this low.” This fear is not unreasonable. It has been buttressed by the likes of Milton Freidman, who noted that inflation was a monetary phenomenon, and Keynes, who indicated that in flush times, it was appropriate to pay off government debts. The combination of continuing fiscal profligacy and monetary stimulus has terrified many a bond manager steeped in Freidman/Keynes teachings.
So what exactly is going on with the bond market, if it is not reacting to inflation, money creation and fiscal policy?
The answer lies in understanding the largest monetary system in the world, a system that is not regulated, is used every minute of every day, and is so opaque that no one has any idea how large it really is: The Eurodollar. A Eurodollar is simply a U.S. dollar held in a bank that is not on U.S. soil. The founding of the Eurodollar system is murky, but my favorite genesis story is that in the 1950s, Russia, wanting to avoid the possibility that the U.S. would freeze its assets during the Cold War, moved its dollar deposits out of reach, from U.S. banks to a Moscow bank with a British charter.
Since then, the Eurodollar market has burgeoned. It dwarfs the assets of every central bank in the world. It received a significant boost as emerging markets began to industrialize because most developing countries issue debt denominated in dollars, to ease acceptance by investors. Banks holding Eurodollars can lend out every red cent; there are no reserve requirements. And underpinning this vast market is the U.S. Treasury market. Treasuries are high quality collateral, absolutely necessary to make this giant monetary system work.
Meanwhile, over the decades, the U.S. economy and its currency supply, while remaining enormous and growing, are becoming smaller as a percentage of the world economy. Yet, the largest monetary system in the world, greasing global trade and growth, demands ever more dollars and ever more Treasuries. This developing gap in supply and demand explains a number of phenomena. For instance, when then-Fed Chairman Alan Greenspan began hiking rates in 2005, the 10-year Treasury was declining in yield, leading to what he termed a “conundrum.” However, during that period, the dollar was generally weak, and foreigners were snapping up Treasuries as if they were going out of style, pushing yields down.
Greenspan blamed this on a global savings glut. It was not. It was a desire to bank dollars for the future, at what was a good price. The complete lack of understanding of the overseas thirst for dollars caused what in retrospect was a dramatic policy mistake, as Greenspan continued to hike rates into 2006. Finally the yield curve responded, and we all know what happened after that.
Likewise, the surge in dollar denominated debt overseas turned problematic again when the dollar rose in the 2017-2019 time frame, causing a scramble for collateral, and forcing the Fed to intervene in repurchase markets to keep things on an even keel. In fact, since about 2010, foreigners have periodically been large net sellers of Treasuries, turning that collateral into Eurodollars, and causing periodic disruptions in our money and bond markets.
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A New Phase
Incrementally, the Fed is losing control over monetary policy in favor of the markets, not the other way around. We are entering a phase when we may see monetary issues every time the U.S. dollar moves rapidly in one direction or the other, foisted on us by borrowers using our currency overseas. Recently, bond interest rates sank despite higher inflation numbers in the U.S. While pundits scrambled to explain the move in the context of the Fed and conditions here at home, the Treasury reported large net foreign sales of U.S. Treasuries in May, the latest month available.
Were these foreign sales another scramble for dollars to pay down loans overseas? Quite possibly, and that would be a signal of deflationary forces at work overseas. In fact, very shortly after that, we began to hear more about the COVID-19 Delta variant, rising cases and more lockdowns. That net sale in May was very likely a positioning move as countries banked dollars.
What are the implications of this for bond management and your clients?
First of all, downward pressure on yields remains a constant in the landscape of bond management. Those who are waiting for the “bond vigilantes” of the 1980s to come back are going to have a long wait. It is likely that the current inflation numbers will barely register in the bond market. Note that we are not saying inflation will go away; instead we may just have to live with negative real rates on a semi-permanent basis.
“Note that we are not saying inflation will go away; instead we may just have to live with negative real rates on a semi-permanent basis.”
Second, there will be opportunities to capture momentarily higher bond yields at times of disruption. We expect disruption to continue rising in frequency. Late 2019 was one of those moments; so was March of this year.
Finally, consider including credit issues in portfolios — municipals, taxable or not; and corporates. These will grant an income edge and if inflation does finally manifest in yields, these issues tend to perform well.
Explaining the larger world of rate trends, not just in terms of our own economic forces but also those of overseas owners of our dollar, is reassuring to investors who have remained puzzled by low rates for so many years. Consequently, advisors may find, as we have, that clients entrust you with balances they previously sequestered in lower yielding options. Clients can benefit from stabilized income levels and very likely, price appreciation, when an advisor is willing to employ these strategies — giving up on higher rates, waiting for the market to correct within the trend, and expanding use of credit product.