Under Pressure

Six years after the start of the financial crisis, interest rates remain at or close to trough levels. Although the Federal Reserve (Fed) and the Bank of England (BOE) are likely to start raising short-term rates next year, the Bank of Japan (BOJ) and European Central Bank (ECB) will maintain ultra-loose monetary conditions for the foreseeable future. As a result, German Bund yields recently fell below 1%, a level that predates the founding of the modern German state. Even in the United States and United Kingdom, two of the developed world’s stronger economies, long-term yields remain stuck at roughly 2.50%. While we do expect long-term rates in the United States to climb modestly, relative to history, interest rates are likely to remain low for an extended period of time.

Low rates are a function of several factors, many of which are being driven by long-term, secular forces. First, long-term rates tend to correlate with nominal growth, which has been below trend since 2000. To the extent that both real growth and inflation are being suppressed — by demographics and debt on the growth side, and demographics and technology on the inflation side — both nominal growth and interest rates are likely to remain below the post-World War II norm.

Second, changes in demographics have an impact on rates beyond slower growth. Older individuals tend to borrow less and exhibit a preference for fixed income. This helps both lower the supply and increase the demand for bonds, in the process, placing more downward pressure on rates.

Finally, there are other factors constraining the supply of bonds as well as increasing demand. U.S. consumer borrowing remains well below its pre-crisis pace and, despite low real and nominal yields, institutional investors are displaying a strong appetite for bonds.

All of this suggests that rates are likely to be “under pressure,” and remain below average well beyond 2015. This is critically important for investors, particularly those who require income, for they may find themselves under pressure as well for some time to come.