Linda Duessel: Hello, and welcome again to the Hear & Now podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. Today, I'm joined again via phone by Don Ellenberger, Senior Portfolio Manager and Head of Multisector Strategies, for part two of our discussion of the bond market. So, Don, are there any clues in the bond market about a sustainable weakness in the dollar, perhaps a new secular dollar bear market?
Don Ellenberger: You have a modest position anticipating the dollar to continue to trade off. As you know, it has been weakening for the past few weeks. The deficit has been growing. The US seems to be behind the rest of the world, particularly Europe and Asia, in terms of where we are on the COVID-19 curve.
Don: You know, the Feds clearly have told us it's going to be a long time before they raise rates, so comparing real rate differentials between US and Europe and Asia, there seems to be less support for the dollar there.
Don: So for a lot of reasons, from a fundamental standpoint, you would think that the dollar should continue to depreciate relative to other major currencies. The only reason why that hasn't been happening a lot or the more specific cases, that's very much a consensus call. I mean, everybody seems to want to be short the dollar.
Don: So I think in the long run, it's going to happen, but it'll probably be more of a grind than a sudden drop just because of technicals in market position window.
Linda: Will the US ever go to negative interest rates if there are what, 14 trillion USD negative global sovereign yields around the world? Does it even matter for savers when our real interest rates are negative as we speak?
Don: Yeah. If you're a saver, you don't want to own any bonds that pay a negative yield because that literally eats your money. You're getting back less than you're giving. You're actually paying for the privilege of lending money to someone.
Don: So we don't own any across our fixed income funds, and I'm not sure it makes sense for many investors; although it's a great deal, obviously, for any company or country that can issue bonds that have negative yields.
Don: I don't see negative yields here in the United States, Linda, for a few reasons. Number one, the Fed has told us that of all the different things they can do, all of the different tools they can use to stimulate the economy, they don't particularly think negative rates are at the top of their list because they're worried about the impact that could have on net interest margin for banks that hurts bank revenue, hurts their profits.
Don: And remember, that's how the Fed implements monetary policy. The tool that implements it for the Feds is going through the banking system. So you don't want to hurt the institutions that are responsible for implementing your monetary policy.
Don: A second reason is that it would absolutely crush money market funds, not good for Federated investors, but also not good for a lot of people who need money market funds as kind of a stable store of value. There are trillions of dollars in money market funds and where would that money go?
Don: And then I guess the third reason is we have seen countries in Europe as well as in Asia, particularly Japan has been employing negative rates across the curve for a number of years now, and hasn't exactly led to strong economic growth. They continue to struggle over there.
Don: So it doesn't seem as if taking rates negative has really helped growth or boosted inflation, which is what central banks are trying to do when they take rates negative.
Don: So for all those reasons, I don't think we need to worry anytime soon about negative rates here in the United States.
Linda: We on the equity side just love how very friendly the Fed is and will probably not like it one little bit when the Fed does raise interest rates. I wonder... What do you think will precipitate the Fed raising interest rates again, and how long do we have until we have to look out for that possibility do you think?
Don: Well, the Fed has told us when they're going to raise interest rates. They're going to move to an average inflation targeting regime, and it's going to be based not on a time period, but on an outcome.
Don: And we all know that the Fed has a dual mandate. So number one is to get inflation at 2% or a little bit higher and to keep it there, not a whole lot higher than that, but not a whole lot lower too; because high levels of inflation and deflation are both equally bad for financial markets in the economy, right?
Don: And the other mandate is to get inflation at the long term sustainable stable level, which the Fed believes is around 4% because the unemployment rate is 10% and it may take a long time to get it back down to 4%. And because inflation has been under a 2% target for most of the last 10 years, the Fed believes it's going to take a while for inflation to get back up to or slightly above that 2% target.
Don: So if they go with average inflation targeting, that means that even when the unemployment rate gets down to 4%, and even when inflation gets to two or slightly above, they're not going to immediately start to raise rates as they had in the past, because they want to make up for the fact that for most of the last decade, inflation has been below their target.
Don: So if you believe what the Fed is telling us, and I have no reason not to believe them, the Fed has to do what they say because that's the most important thing they could do. People have to believe that Fed's going to do what they say and you know, rates aren't going to go up for quite a long time. We're talking years, not quarters or months.
Don: And if you look at like Fed fund futures or Eurodollar futures, it doesn't show even a 25 basis point, a meager 25 basis point hike until four years from today.
Don: And if you look 10 years from today, the Fed funds futures or Eurodollar futures markets are telling us that the Fed funds rate is going to top out at 1-1/4% in the year 2030.
Don: So what the market is saying and what the Fed is saying, they're kind of consistent saying that rates are going to be low for a long period of time. And in my sense, and you're the equity expert, not me; but periods of low and stable interest rates tend to be very fertile periods for risk assets in general, whether you're talking stocks or corporate bonds.
Linda: We know that the baby boomer generation controls 80% of the investible money out there, and we plan to live a long time; but we need income and we're looking for reasonably defensive income. With rates as low as what they are across the yield curve, is a 60/40 asset allocation role relevant anymore?
Don: No. My own personal cut, Linda, I'm probably about 82/18... 82% in equities and 18% in bonds. I'm a bond guy. So yeah, if you look at longer term, studies have shown that the best prediction of total return for any kind of bond is it's starting yield.
Don: So if you go back to the 1980s, when yields were double digits, you did actually realize double digit returns in bonds. But remember now, we're starting with treasury yields and the treasury bond index at 0.5%. That's the average yield of all treasury bonds from one year up to 30 years at 0.5%. So the best guess for the return of treasury bonds into the future is not even 1%.
Don: You get a little bit more if you're in investment grade corporate bonds, a little bit more than that; but if you're in something like the aggregate bond index or core or core plus bond fund that looks like the aggregate index, right now the yield on that is less than 2%. So the expectation in the future is that you're going to be hard pressed to get more than 2% out of bonds going forward.
Don: So if you need more than that to survive on, then yes, absolutely, I think you need to have a higher allocation of equities. And if we're right in our assumption that rates are going to stay low and stable for a long period of time, then I think that's the place to be.
Linda: Crazy times indeed. So thank you so much, Don, and thank you to our listeners. We look forward to you joining us again on the Federated Hermes Hear & Now podcast.
Linda: If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Hear & Now episode plus our other series, Amplified & Fundamental for a global perspective on the issues, challenges and trends shaping the investment landscape.
Disclosure: Views are as of Aug. 21, 2020 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices. International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Past performance is no guarantee of future results. The value of equity securities will rise and fall. These fluctuations could be a sustained trend or a drastic movement. 20-40410 (9/20) Federated Investment Management Company