Global Interest Rates Rise on Improving Economic Data
After falling for most of the year, the U.S. 10-Year Treasury yield reached 2.13% on June 26 – its lowest level of 2017. Subsequently, the 10-Year increased 23 basis points (bps) to 2.37%. Admittedly, the rise in rates is anything but eye-popping. We have seen three other 25 bps bumps in U.S. 10-Year yields in 2017 alone, each time rising to lower highs and later falling to lower lows (see chart below).
Figure 1: The U.S. 10-Year Treasury Rebounds
Source: Thomson Reuters DataStream, 7/7/17.
The difference for us this time is the level of global participation in rising interest rates (see chart below). The German 10-Year Bund yield, for example, surpassed 0.5% early Thursday morning (7/6/17) for the first time since January 2016.
Figure 2: Global Interest Rates Rise in Tandem
Source: Thomson Reuters DataStream, 7/7/17.
The global selloff in bonds likely came as central bankers around the world shift from a near decade of accommodation to something relatively less accommodative. The U.S. Federal Reserve (Fed) has increased interest rates a total of four times since it began in 2015, and members have stated intentions to begin on a path of balance sheet normalization. Europe is a long way from actually tightening, but Mario Draghi and the European Central Bank (ECB) have adopted a less dovish tone. And in China, Central Bank authorities are on a strategic tightening path.
We believe, however, the recent stable and robust economic data is ultimately responsible for the increase in interest rates. Central bankers would not even consider normalization, were the global economy not on firm ground. And recent softness in inflation is clearly viewed as temporary by both the Fed and the ECB, as they appear resolute to normalize monetary policy. We expect tighter policy will continue to unfold at an extremely gradual pace.
Rising-bond yields are unequivocally negative for owners of fixed-coupon bonds, although they offer a more attractive entry point for new cash.
For equities and credit, the relationship is not as direct. On one hand, if rising yields reflect accelerating growth, this is a positive for risk-on assets as there are more earnings to distribute or reinvest and improved repayment prospects. On the other hand, if rising yields reflect tighter policy as the Fed raises interest rates and allows its balance sheet to runoff, the news is less positive for risky assets, as it implies higher borrowing costs without a connected improvement in economic growth.
Rising yields outside of the U.S. helps to dampen any currency impact that might otherwise occur. For example, the U.S. dollar might appreciate if yields rise faster at home than abroad. With rising global yields, the effects should be more muted. A relatively stronger dollar poses a headwind to multi-national companies with international revenues.
The Bottom Line
Yields remain low, implying an unattractive payoff to those bearing interest-rate risk. At the same time, global economies show strong pace of growth. As such, we continue to shy away from high quality, long duration assets in favor of pro-cyclical securities, particularly those outside of the U.S.
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Bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. If an issuer stops making interest and/or principal payments, these securities may be worth less and the fund could lose its entire investment.
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Basis point (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
Germany 10 Year Bond – The rates are comprised of Generic German government bonds.
Gilts are bonds that are issued by the British government, and they are generally considered low-risk investments. Gilts are the U.K. equivalent of U.S. Treasury securities, and the name originates from the original certificates, issued by the British government, which had gilded edges.
Japan 10 Year Bond – The rates are comprised of Generic Japanese government bonds.
Treasury Yield is the return on investment, expressed as a percentage, on the U.S. government’s debt obligations (bonds, notes and bills). In other words, the treasury yield is the interest rate the U.S. government pays to borrow money for different lengths of time. The different types of U.S. Treasuries include Treasury notes, Treasury bills and Treasury bonds, which come in different maturities up to 30 years. There are one-month, three-month, six-month, one-year, two-year, three-year, five-year, seven-year, 10-year, 20-year and 30-year securities.
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