FIXED INCOME MONTHLY

How low can interest rates go?

Jul 20, 2016 / By Jeffrey Rosenberg

Neither Brexit nor a strong June jobs report were able to stop rates from heading further south. With global economic uncertainty still prevalent, the next big question is whether they can head even lower.

 


Fixed income highlights

  • How low can interest rates go? With U.S. 10-year interest rates making new lows in July, a surprisingly strong payrolls report for June could not even shake rates higher. Brexit uncertainties represent a meaningful shock to the outlook; the uncertain aftermath keeps the Federal Reserve’s (Fed) path to normalization on pause, pulling the range for rates 25 to 50 basis points lower. With greater downside to the economy eventually realized, rates could go even lower.
  • Understanding global demand for U.S. Treasuries. Further underlying the outlook for low U.S. rates, zero and negative rates in other developed markets make U.S. rates relatively attractive. But the story is slightly more complicated than that. A shift in the composition of foreign holders of Treasuries towards private (vs. “official”) raises the importance of considering hedging costs. Those hedging costs have been increasing, reducing the attractiveness to foreigners of U.S. debt on a hedged basis. Rather than just interest rate differentials, it’s the flattening of global rate curves that keeps pushing lower longer-maturity U.S. rates.
  • Limits to “No Limit.” QE and NIRP (quantitative easing and negative interest rate policies) are powerful combinations for global bond markets. The result of Brexit increases expectations for further European Central Bank (ECB) and Bank of Japan (BoJ) accommodation. But that means even greater pressure on long-end yields as the limits to QE in debt availability force central banks into longer-maturity bond purchases.

Strategy and outlook

Upcoming key events in late July include the BoJ policy meeting along with anticipated additional fiscal policy accommodation. In Europe, the results of the EU-wide stress tests to be announced July 29 hold significance critically for the Italian banking sector. Post-Brexit, the resulting economic uncertainty pauses the Fed’s path towards normalization. While U.S. equity markets appear to take comfort in the postponement, we worry a bit more about the complacency in what lies ahead: little further room for monetary policy accommodation to effectively stimulate the real economy. That keeps us cautious on U.S. credit, favoring higher credit quality instruments with greater liquidity, upgrading investment grade. Longer duration continues to be a focus as global accommodation supports the back end of U.S. curves. Pausing Fed normalization stabilizes the outlook for emerging markets (EM) debt, and we upgrade the sector this month. And extended moves lower in global developed market rates, alongside a stable to favorable outlook for the U.S. dollar, lowers our recommendation on non-USD for USD-based investors.

Jeffrey Rosenberg
Managing Director, Chief Investment Strategist for Fixed Income
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Investment Strategist for Fixed Income which is responsible to develop BlackRock's strategic and tactical views on sector allocation within fixed income, currencies and commodities.
Jeffrey Rosenberg
Managing Director, Chief Investment Strategist for Fixed Income
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Investment Strategist for Fixed Income which is responsible to develop BlackRock's strategic and tactical views on sector allocation within fixed income, currencies and commodities.