Slow and steady rate hikes suggest government debt has a role in asset allocation, says Russ Mould.
To this observer, who is admittedly sat on the other side of the Atlantic Ocean, the US Federal Reserve finds itself in a quandary.
The rhetoric from chair Janet Yellen, her deputy Stanley Fischer and several other members of the Federal Open Markets Committee (FOMC) – notably John Williams of the Federal Reserve Bank of San Francisco – suggest that the American central bank is itching to raise interest rates.
Yet when it came to the first five of the FOMC’s eight meetings in 2016, the Fed elected to do nothing, even after talking a good game. Equity markets have been taken in, wobbling ahead of or after every Fed pronouncement, but bond investors have resolutely refused to be fooled.
Grinding lower
The US 10-year and 30-year Treasury bond yields have ground remorselessly lower, providing advisers and clients with welcome capital gains (at least on paper) to supplement the regular income they provide in the form of coupons.
It is possible to gauge what the market is pricing in by way of Fed activity by looking at the CME Fedwatch tool, which summarises the market’s views on the likelihood of changes to headline interest rates in the form of a percentage. For the next scheduled FOMC meeting in November, the market is expecting a 92% chance of no interest rate change and just an 8% chance of a 0.25% rate hike from Yellen.
The market does seem to be favouring a 0.25% increase towards the end of the year, but probability still sees the rate staying in the 0.5% to 0.75% range well into 2017 (see Fig. 1, below).
If this is correct, then the 1.53% yield available on the US 10-year and 2.22% yield on the 30-year may still tempt income-hunters.
This is especially so given that these figures easily outstrip what is available from other leading developed sovereign bond markets (see Fig. 2, below) and the buyer gets access to the world’s reserve currency, the dollar, at the same time.
Macro concerns
For all of the confusion sown by the Fed, it is relatively easy to understand why it remains nervous of raising interest rates, even if it would like to begin the process of normalising monetary policy after eight years of record-low borrowing costs and trillions of dollars in quantitative easing.
First, headline GDP growth remains ordinary at best: barely 1% annualised in the first half of 2016 – a rate unlikely to stir the trigger finger of any member of the FOMC.
Second, the US is awash with debt. The government deficit stands near $16trn and is moving above the 80%-to-GDP threshold, which Carmen Reinhart and Kenneth Rogoff identified in their book This Time It’s Different as the level where debt can start to weigh on an economy and crimp growth.
Data from the St. Louis Federal Reserve shows that the amount of outstanding commercial and industrial loans in the US has all but doubled to $2.1trn since 2007.
In addition, figures from the Federal Reserve Bank of New York show that total US household debt is more than $11.5trn – comprising $8.4trn in mortgages, $1.3trn in student loans, $1.1trn in auto loans and $700bn on credit cards (equivalent to more than $250,000 per household). Any gallop higher in interest rates would smother consumer spending and puncture what little growth that the US is generating.
Third, there is one area where the US is showing considerable growth: corporate bankruptcies. August’s figures from the American Bankruptcy Institute show a 29% year-on-year increase, the 10th consecutive month of higher failures, according to finance blog WolfStreet.com. This is at a time when bond yields are plunging and interest rates are anchored near zero.
Looking at this another way, the delinquency rate on US commercial and industrial loans is still just 1.6%. But it has doubled from its late 2014 low of 0.72% – and that at a time when the US economy is allegedly doing well (see Fig. 3, above).
All of this suggests any rate hikes will be slow and steady (assuming they come at all). It is a situation which still suggests government bonds may have a role to play in asset allocation, especially if they offer a positive yield and come in dollars.
Granted, long-dated paper comes with greater price volatility. But seeking out flexible allocation bond funds with an exposure to long-dated US government debt is one option to consider for patient, income-hungry clients.
Russ Mould is investment director at AJ Bell
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