Jul 10, 2019 Fixed Income

Bonds – falling interest rates may cause yields to crumble

Major central banks have given firm indications that they will once again loosen monetary policy this year. This is also weighing on bond yield expectations.

  • Central banks on both sides of the Atlantic want to tackle weak economic growth and low inflation by loosening monetary policy.
  • Key interest rates in the USA and bank deposit rates in the eurozone will probably be adjusted accordingly by the end of the year.
  • Yields on US Treasury bonds and eurozone corporate bonds in particular could begin to crumble over the next few months.
4 minutes to read

Fed chairman, Jerome Powell, and his counterpart at the European Central Bank, Mario Draghi, agree on one thing: interest rates now need to fall before they can rise again. Both have said as much. Powell and Draghi both see growing risks that could cause serious shock waves in the economy and on financial markets. These include a potential war in the Middle East, a hard Brexit, a new budget crisis in the eurozone, and ever more tariffs because of international trade wars. Christine Lagarde, who will take over Draghi's job in November, is likely to see things the same way. The latest side swerve in central bank monetary policy is particularly important for bond investors. We consider six questions and answers:

1. Why are interest rates now being lowered again – should interest rates not have returned to normal a long time ago?

In the eurozone, so far nothing is normal as far as interest rates are concerned. Base rates are at zero, and the deposit rate -- the interest rate for banks that can park their money at the central bank – is actually negative. In light of continuing weak economic growth, geopolitical risks and stubbornly low inflation, ECB president Draghi is now arguing that the euro central bank could soon react with further interest rate reductions or even renewed bond purchases. For a central banker that is very straight talk, which is why markets are taking his words seriously.

It is different in the USA. There, interest rates rose in the past couple of years to reach the current range of 2.25 to 2.50 percent. However, Fed boss Jerome Powell’s diagnosis is now also that worldwide economic data are set to deteriorate. He also points to the huge risks that an international trade war presents. Investors are also reading his statements as a clear indication that interest rate reductions are in the offing.

The Fed is likely to cut rates, and the ECB to drive its deposit rate even further into negative territory.

Government bond yields are likely to fall, while corporate bonds should remain comparatively stable.

2. How low are interest rates likely to go?

DWS experts expect the Fed now to cut the base rate twice in the next twelve months by a quarter of a percentage point each time,  or a total of 50 basis points (100 basis points = one percent). The ECB is likely to respond with a cut to its deposit rate. Currently, this rate is sitting at minus 0.4 percent. DWS estimates suggest it will drop by a further 0.1 percent. Both central banks hope this will keep the fragile economy on course, above all normalising inflation rates in the eurozone in the medium term.

3. What effect will this have on the bond markets?

The bond market is a good barometer of investors’ future interest and inflation rate expectations. Market returns on many fixed-interest investments have fallen recently. It therefore looks like not just central bankers but also investors are not expect the long-awaited interest rate reversal to happen anytime soon. That also seems to be true of a return to "normal" inflation rates. The ECB's inflation rate target is almost two percent; in practice inflation was 1.2 percent in the last few months.

Adjusted twelve-month forecast for government bonds

Currently
21. June 2019*
Forecast
June 2020
Government Bond Yields
US (2 years) 1.90% 1.70%
US (10 years) 2.13% 2.00%
US (30 years) 2.61% 2.50%
US Municipal bonds* 77.78% 80.00%
Securitized / MBS* 40 bp 38 bp
Bund (2 years) -0.68% -0.70%
Bund (10 years) -0.23% -0.10%
Bund (30 years) 0.38% 0.40%
Italy (10 years) 265 bp 270 bp
Spain (10 years) 83 bp 80 bp

Looser monetary policy is likely to have the biggest impact on yields on US debt instruments.

DWS forecasts 24 June 2019 (F=Forecast). Forecasts are based on assumptions, estimates, opinions and hypothetical models or analyses that may turn out to be incorrect. No guarantee can be provided that investment goals or income expectations will be reached. // * the current value is based on the rolling 20-day average// * US municipal bonds: Ratio of 10y AAA / US Treasuries; Securitised/ MBS: FNMA 30y -7y US Treasuries; Federal funds rate; The target value matches two interest rate cuts in the next 12 months// Sources: Bloomberg Finance L.P., DWS International GmbH; as of June 2019

4. What should government bond investors now bear in mind?

According to new DWS forecasts, yields on a whole swathe of fixed-interest securities are now likely to fall over the next twelve months – and prices, as is normal for bonds, to rise accordingly. If you take one of the most important global interest rate indicators, the 10-year US Treasury bond, estimates suggest its market interest rate could fall from 2.13 percent currently to 2.0 by June 2020. Across all maturities, experts have reduced their forecasts for US Treasury bonds by 0.3 percentage points – 30 basis points.

5. What is the outlook for German and European government bonds?

The picture there looks a little different. The primary indicators of future interest rate expectations, the 10-year German "Bunds", currently offer negative yields anyway, which hardly makes them attractive investments. For riskier eurozone government bonds, such as issues from Spain and Italy, we expect the risk premium to shrink, resulting in lower yields. One reason for this could be the hope – which Draghi has now held out – that the ECB will revive its bond purchase programme. That should create more market demand, support prices and put yields under pressure here too.

6. Which bond segments currently exhibit potential?

For the short term, DWS sees potential in corporate bonds with good credit ratings (investment grade) from the USA and Europe, as spreads with government bonds are shrinking, which means prices should rise. Emerging-markets bonds, both government and corporate, offer significantly higher yield than their European and US counterparts.

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