Post-election outlook for interest rates and bonds – and why we believe now’s not the time to dump bonds

Post-election outlook for interest rates and bonds
Since the U.S. election on Nov. 8, global capital markets have been sorting out what a Trump Presidency might imply for the global economy. Within the first 8 market days post-election (as of Nov. 18 close), the 10-year U.S. Treasury yield rose 50 basis points to 2.36% which suggests that the bond market is heralding the President-Elect’s campaign pledges in favor of deregulation, tax cuts, and infrastructure spending as potential catalysts for an improving economy.

This sudden spike has created a challenging environment for many bond investors as core bonds (represented by the Bloomberg Barclays U.S. Aggregate Bond Index) have pulled back -2.2% for the same period ending Nov. 18. This experience has prompted questions about where interest rates may go from here, and whether bonds should be reduced or eliminated from multi-asset portfolios. The quick answers are: “likely gradually up,” and “No, bonds will continue to play a meaningful role in a diversified portfolio.”

Outlook for bonds

We do believe that interest rates will continue to trend up. The Economic Indicators Dashboard offers some helpful reference points in this regard:

  • The Yield Spread reading (which measures the difference between short-term and longer-term rate levels) reflecting a positive sloping yield curve suggest that the bond market continues to price in “growth” for the economy. At Russell Investments we concur with this notion that the economy will continue on its positive trend growth which may put upward pressure on rates.
  • The 10-year Treasury yield reading shows that the 10-Year rate is still at a historically low level and there is the eventuality of reversion back towards long averages. Today’s levels indicate there is still a significant way to go before approaching those averages.

However, it is likely that rates will move at a more modest pace than experienced since the election and the recent period since the Brexit vote in the United Kingdom (which prompted 10-year U.S. Treasuries to touch a generational low of 1.36% on July 8). The realization that Europe wasn’t going out of business and that economic growth would continue gave rates a lift from that historic bottom. Combine this momentum with speculation surrounding President-Elect Trump’s economic policies, and rates received a significant, although likely unsustainable, near-term boost in the past few weeks.

It’s unlikely that rates will maintain their breakneck pace, but the Federal Reserve appears to be pointing towards a December rate increase at the short-end and continued economic growth is likely to support higher rates going forward. This will act as a headwind for bond investors as rising rates bring down bond prices. However, the higher rates do come with higher coupons which will hopefully buffer some of the price declines, leading to more modest bond returns looking ahead, instead of negative bond returns as seen in recent weeks.

The role of bonds

A rising interest rate environment can cause discomfort for investors, especially those focused on their bond portfolios. However, rising rates aren’t all bad when viewed from a total portfolio perspective and within the context of bonds’ dual role as diversifier and income producer:

  1. An increase in rates is generally reflective of a growing economy, which tends to support positive stock returns – the long-term growth engine of a portfolio.
  2. Although bonds themselves don’t benefit as such in this environment, they remain the primary diversifier of the equity portfolio and help target a manageable risk profile for the overall portfolio. Bonds have played that role since the election (as of Nov. 18) in the sense that they have not moved in-line with the equity rally. But, the relationship works in reverse, too, so bonds will demonstrate their worth during periods that are more challenging for equities.
  3. Market environments that are rough for equities typically come suddenly and unexpectedly. It’s best to be prepared in advance than trying to time those periods where bonds are a crucial part of the portfolio.
  4. Rising interest rates come with a higher coupon on bonds which can help provide some cushion against rate increases and higher income for income-seeking investors.

The bottom line

Recent weeks have seen a lot of movement in interest rate markets. It’s likely that rates will continue to rise gradually. Remind clients that although rising rate environments tend to be challenging for bonds, that asset class can still play the critical role of diversifying the equity portion of the overall portfolio. Yes, bonds will trail equities during the good times, but they have historically demonstrated their worth during those unexpected, trying periods, which usually don’t announce themselves in advance.