How low can U.S. Treasury yields go?
Worries about the spread of the COVID-19 virus continued to grip markets this week. Dramatic declines in equity prices understandably received a lot of attention. Just as dramatic though, have been the fall in yields across high quality developed market government debt. The U.S. 10-year Treasury (UST) yield declined to 1.02% by Tuesday’s close. This is a record low.
As 2020 began, we were having discussions about shifting portfolios to more defensive stances. Even though it was expensive, a relatively higher allocation to high quality government bonds still looked attractive in an environment where we thought volatility would rise and the global macroeconomic cycle was moving into a later stage. This was our view before the most recent bout of market turbulence on the back of worries about a global pandemic. Market performance since these worries arose offers an illustrative example about the role fixed income can play in portfolios, but also highlights the challenge facing investors and central bank policymakers alike. Both are wondering if UST yields can go lower, and if yields do go lower what should investors do for income?
Before this past week, the lowest UST 10-year yields traded in recent memory was when they dipped below 1.40% in July 2016. Three things seem to be driving this week’s drop: fears about a global recession, an equity market selloff and reactions to and expectations for Federal Reserve (Fed) action. All of these factors are, of course, connected, but are worth thinking through individually.
The ripple effect of supply chain disruptions in China from the virus, lowered consumer spending in China and abroad as people stay home, and lower business activity as companies wonder how long it will take to get back to normal operations have all contributed to rising fears of a major slowdown in global economic activity. Recent Purchasing Managers’ Index (PMI) data reflect these factors. The global manufacturing PMI reading for March indicates a steep decline from February’s activity levels. Such a decline has raised even more fears of a recession, which has sent many investors scurrying for safe-haven assets like U.S. Treasuries, driving up prices (Exhibit 1). Bond yields and prices move inversely of one another.
Equity markets globally have priced in these same worries. Dramatic declines around the world have prompted headlines in recent weeks. Traditionally, a portfolio is built of both fixed income and equities so that when equities decline, bonds rally with the end result being an investor is protected from turbulence in the equity market. Recently, that has not been working out so well for investors. Fixed income and equities have rallied at the same time, prompting many of us to ask whether we need to rethink our approach to portfolio construction. Over this past week, a defensive allocation to core fixed income has paid off as equity declines have been offset by a rally in bond prices.
EXHIBIT 1: U.S. TREASURY 10-YEAR YIELD AND GLOBAL MANUFACTURING PMI
As worries about a recession have risen, investors naturally have asked how central banks will respond. Many banks in Asia have already cut rates or pursued additional easing measures. Expectations for action by the European Central Bank are rising. The Fed announced emergency cuts of 50 basis points ahead of its next scheduled meeting on March 18. The Fed’s decision to both take policy action outside their normal meeting schedule and to cut rates by 50 basis points (the Fed has traditionally moved in increments of 25 basis points) reflects their perception of how disruptive the COVID-19 outbreak may be to the global economy. Markets had fully priced in this action, but for the March 18 meeting, and are expecting further easing. Recent Fed behavior suggests that they will respond to market desires. In many cases, we seem to have moved from “don’t fight the Fed” to the Fed not being willing to fight markets. A lower policy rate implies lower yields in government bonds all along the curve, meaning we may see further declines in government bond yields—just as we did after the Fed’s surprise rate cut.
Collectively, low yields in government bonds mean investors who already allocated to these assets were able to offset some of the price declines in their equity holdings over recent weeks. For those who did not already own these bonds, expensive assets have gotten even more expensive. For all investors, a price increase in government bonds means even lower income from their fixed income holdings. This situation is most acute for those holding European and U.S. assets, but affects investors globally. To manage portfolios in this context, investors may want to still consider allocations to high quality fixed income as a defensive cushion for their portfolios, but rely on corporate credit or alternative assets for income.