What Is Normal?

Fixed income investors have had a rough time over the last few years. Normally a staid asset class, core bonds (as proxied by the Bloomberg Aggregate Bond Index) have seen negative returns over the last two calendar years and could potentially see negative returns for a third straight year—something that has never happened in the history of the core bond index (since 1975). But despite the rapid rise in interest rates (fall in bond prices), there’s no reason to believe that we are in the beginning of a sustained bear market. Just because yields fell for many years doesn’t mean that they have to keep rising. In fact, at current levels, after years of artificially suppressed levels, long-term yields are back within longer-term ranges. In this edition of the LPL Street View, LPL Chief Fixed Income Strategist Lawrence Gillum asks and answers what is normal for interest rates.

The 1980s were a time of parachute pants, great movies, and even better music. Throw in the release of Pac-Man and the launch of MTV (when they actually played music videos) and the 80s were largely considered to be the best decade ever! The 1980s also saw the start of one of the most impressive bull market runs in recent history. The start of the bond bull market.

In an effort to arrest stubbornly high inflationary pressures, and after arguably several policy mistakes, the Federal Reserve (Fed) raised short-term interest rates to 20% in the summer of 1981. The rise in short-term interest rates pressured long-term interest rates higher as well, which peaked above 15%. The rise in short-term interest rates ultimately ended the generationally high inflationary pressures and interest rates have more or less fallen ever since… until 2020. With inflation rearing its ugly head again, the Fed embarked on another aggressive rate hiking campaign and has taken short-term interest rates to 5.5% (upper bound) definitively ending the bond bull market. But just because interest rates have stopped going down doesn’t mean that they have to keep going up either.

Zooming out, and looking at interest rates over a longer time horizon, provides perhaps a bit more clarity on what could be considered normal for interest rates. Data since 1880 shows that interest rates were in a fairly tight range before the spike in interest rates that took the 10-year Treasury yield to those very lofty levels in the 80s. In fact, long-term rates mostly traded within a 3% to 5% range for nearly a century before moving aggressively higher as the Fed fought those generationally high inflationary pressures. Now, each security on the Treasury yield curve can be thought of as the expected fed funds rate over the maturity of the security, plus or minus a term premium. So, periods outside of that 3% to 5% range have been due to the economy’s growth and inflation dynamics, which ultimately shapes the Fed’s interest rate policy.

As for the recent deviation from normal, in the aftermath of the Global Financial Crisis, the U.S. experienced a decade of sluggish growth and subdued inflation. Additionally, central banks, globally, engaged in aggressive bond buying schemes to provide liquidity and stability to markets. Throw in a once in a century global pandemic and interest rates were kept at very low levels—one could argue artificially suppressed levels. The Fed and other central banks ripped the proverbial Band-Aid off over the last few years and interest rates are now back into more normal levels.

Could interest rates go higher? It’s possible. With the Treasury Department expected to issue a lot of Treasury securities to fund budget deficits and with the potential for the Bank of Japan to finally end its aggressively loose monetary policies we could continue to see upward pressure on yields. However, while supply/demand dynamics can influence prices in the near term, the long-term direction of yields is based on expected Fed policy. So unless the Fed isn’t done raising rates due to a resurgence of inflationary pressures (we don’t think that is likely) the big move in yields has likely already taken place. Inflation is trending in the right direction and the Fed could be near (at?) the end of its rate hiking campaign. That doesn’t mean rates are going to fall dramatically from current levels though and that is fine for the longer-term prospects for fixed income investors.

So, if we are in this new normal regime with higher interest rates, what could fixed income investors expect? So, if the 10- Treasury yield is going to average say around 4% over the next decade, which is what it generally averaged in the decade before the Global Financial Crisis (GFC), that could be good news for bond investors: from the start of 2000 until the global financial crisis, the Bloomberg Aggregate Bond Index generated around 6% average annual returns- nearly twice what the index returned in the decade after the global financial crisis when long term rates were lower. Paradoxically perhaps, the longer Treasury yields stay higher, the more enduring fixed income is as an asset class. Starting yields are the best predictor of future returns (over longer time horizons), so if Treasury yields remain elevated that means yields for other bond asset classes will be higher as well which means fixed income returns could be higher too. So while we may see the resurgence of parachute pants, we don’t think we get back to those lofty interest rate levels last seen in the 80s now that things are seemingly back to normal. 

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