- Market Insights
- 5 mins
One of the far-reaching impacts of the nationwide shutdown due to the novel coronavirus has been on interest rates. The sudden slowdown in economic growth, the Fed's emergency monetary policy, low inflation, and longer-term growth trends have collectively pushed Treasury yields to historic lows. And while the economy is beginning to reopen, it may take much longer for rates to fully recover - if they do at all. It's important for all investors to have perspective on interest rates and what they could mean for investment portfolios as the economy stabilizes.
From a historical perspective, low rates are both nothing new and the result of more than just Fed policy. Interest rates have been declining steadily for almost 40 years since the 10-year Treasury yield peaked at nearly 16% in 1981. Stagflation (stagnant growth plus inflation) in the 1970s then gave way to the so-called Great Moderation. It's likely that this era of steadier business cycles, combined with a glut of global savings searching for yield and technological deflation, resulted in downward pressure on rates.
Of course, the 2008 financial crisis was another nail in the coffin as the Fed instituted emergency monetary policy and pushed the federal funds rate to zero. Slow but moderate growth during the recovery that followed kept the 10-year Treasury yield under 2.5% on average. While various Fed actions including the end of asset purchases and the short-lived unwinding of its balance sheet led to volatility in rates, they never resulted in sustained increases. At this point, with the federal funds rate back at zero and the Fed balance sheet ballooning past $7 trillion, it's difficult to see how these policy trends will reverse.
It's hard to overstate the importance of interest rates across the economy. However, it's important to distinguish the micro-economic effects on our everyday lives from the macro-economic consequences for our investment portfolios.
At the micro level, low rates hurt savers, especially those who rely on interest income. Over time, inflation - even at modest levels - erodes the real value of savings if interest rates aren't high enough to combat it. However, low rates are great for borrowers including new and existing homeowners and small businesses. While it may be difficult to access credit at these lower rates for the time being, cheaper rates could help boost growth once the economy reopens and the financial system stabilizes.
At the macro level of the economy and markets, there are at least three effects that are important. First, interest rates are a signal about economic health. Over time, faster growth should spur inflation and push up both real and nominal interest rates. Conversely, low interest rates suggest worrisome expectations of future growth. From this perspective, it's no surprise that rates have suddenly declined due to pessimism and uncertainty about COVID-19 and the future in general.
Second, how interest rates move relative to one another is important too. The yield curve inverted last year (i.e. long-term rates were lower than short-term ones), suggesting that there were stresses building in the economic and financial system. While it's implausible that the yield curve predicted the coronavirus-induced recession, it does suggest that markets didn't believe the Fed could maintain high short-term rates. With the Fed having lowered those rates to zero, the yield curve has returned to a more "normal" upward-sloping shape.
Third, low interest rates tend to boost stock market valuations. While this is not a one-to-one effect, and often depends on why interest rates are low, there does appear to be a substitution effect between stocks and bonds. When Treasury and high-grade bond yields are low, stocks become more attractive both in terms of their dividend yields and the reduced opportunity cost of holding risky assets. Although there are many trends to tease out, market valuations were certainly elevated at the onset of the COVID-19 crisis.
Although the economy is beginning to reopen, there could continue to be pressure on interest rates. There will no doubt be more terrible backward-looking economic numbers in the coming months. Additionally, many government bond yields in other parts of the world - most notably Europe - are still in negative territory.
For long-term investors, it's important to stay balanced as economic uncertainty continues. This is because the flip side of falling interest rates has been rising fixed income prices. Thus, even when the asset class generates little income, bonds still help to stabilize portfolios, just as they have done throughout this year. Below are three charts that help to put historically low interest rates in perspective.
1. Interest rates are at historic lows
Historical Interest Rates
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Interest rates have been declining over the past 40 years. However, many of the factors that have affected rates over the past few decades are related to longer-term trends such as slowing growth, demographics, a glut of savings, technology, and more.
2. Rates have plummeted since late 2018
Interest Rates in Perspective
Find this chart under "Interest Rates"
More recently, interest rates have plunged to new historic lows as the economic shutdown from the novel coronavirus has rattled markets. Rates began this decline during the market volatility of late 2018. Over this period, the 10-year Treasury yield has fallen by nearly 2.6%.
In the near-term, low rates, if they are available to borrowers, could help the economy as it reopens.
3. Bonds have helped to stabilize diversified portfolios
Asset Classes Relative to U.S. Stocks
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Although government and high-grade bond yields have generated little portfolio income for investors over the past decade, they have still helped to stabilize portfolios. There is no better proof of this than this year. Diversified bonds are outperforming other asset classes and have helped support balanced portfolios.
The bottom line? Interest rates are near historic lows which could boost the economy over time. Investors should continue to be diversified with stocks and bonds to navigate economic uncertainty.
