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Lower Yields Coming To The United States

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Includes: AGG, BIL, DFVL, DFVS, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, GBIL, GOVT, GSY, HYDD, IEF, IEI, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTI, SPY, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Josh Ortner
Summary

Financial institutions such as JP Morgan are beginning to consider 0% interest rates in the U.S. in their recent risk management plan.

The CME Fed Watch Tool calculates an 88% chance of a .25bps rate cut in seven days at the next Federal Reserve meeting.

Euro area interest rates continue lower with Germany flirting with negative rates.

Profit from rate cuts buy purchasing long-bond ETFs such as the iShares Barclays (AGG) or iShares 10-Year Treasury ETF (TLT).

The recent chatter among interest rate observers is the chance of the United States Treasury note paying nothing, nada, zilch. My take is the consensus for once is right. One trusted interest rate observer is now preparing his bank for a 0% interest rate environment; CEO of JPMorgan Chase (NYSE:JPM), Jamie Dimon. "I personally don't think we will have zero rates in the U.S., but we at JP Morgan are thinking about how to prepare for it, just in the course of risk management," Dimon said at a conference in New York. Mr. Dimon also admitted in the interview that the recent drop in rates has shocked him as he thought they would naturally progress higher. Alan Greenspan was on CNBC's squawk box explaining that there is currently more than $16 trillion in negative yielding debt around the world as central banks try to ease monetary conditions to sustain the global economy. “You’re seeing it pretty much throughout the world. It’s only a matter of time before it’s more in the United States,” Alan Greenspan told CNBC. The recent drop in rates to new lows here in the U.S. is nothing compared with what we are seeing in other developed nations like Germany.

Euro Area Rates Heading Lower

It pays to be an observer of worldwide interest rates, especially with our friends in Europe. The European Central Bank (ECB) decided to leave its main interest rates unchanged at its July 25th meeting, but tweaked its forward guidance suggesting that it will unveil a broad package of monetary stimulus at its September meeting. Accordingly, rates continue to sit at record-low levels: The refinancing rate sits at 0.00%; the marginal lending rate at 0.25%; and deposit facility rate at minus 0.40%.

(Source: Trading Economics)

I believe the U.S. is heading the same way as the euro area. The soft economic data, persistently low inflation, modest inflation expectations and ample downside risks to the outlook have put pressure on the ECB to unleash stimulus to shore up the outlook. It is a matter of time before the Federal Reserve runs out of rate cuts to the fed funds, and will have to go back to stimulus packages just like the ECB is doing.

Germany 30-Year Flirting With Negative Yields

The yield curve I have been watching just as close as the U.S. is the German yield curve. German banks (DB) are trying to figure out the right way to handle the recent negative yields, costing depositors money to save. As the German government debates banning negative yields, banks are warning that this move could cause "dangerous instability" on worldwide financial markets. The ECB's deposit rate of -.4% is costing German banks roughly 2.4 billion euros.

(Source: Trading Economics)

The German 30-Year rate is trading just above zero as of yesterday as talks of stimulus are push yields higher now. A return of the 30-year bond to a positive yield would mean the entire curve of the euro zone's benchmark bond issuer would no longer be in negative territory anymore. However, I would not hold my breathe as rates continues to flirt with that zero line.

The CME Fed Watch Tool Calculates An 88% Chance Of A Rate cut

Coming back to recent news here in the U.S. shows that market participants believe the Fed will cut rates again. Just as savers and investors were finally starting to receive interest on their savings, the Fed looks to cut rates again to spur more economic growth.

TARGET RATE (BPS) PROBABILITY(%)
NOW 1 DAY10 SEP 2019 1 WEEK4 SEP 2019 1 MONTH9 AUG 2019
150-175 0.0% 0.0% 10.8% 15.4%
175-200 88.8% 92.3% 89.2% 84.6%
200-225 (Current) 11.2% 7.7% 0.0% 0.0%
*Data as of 11 Sep 2019 08:50:04 CT

(Source: CME Group)

From the table above, the market seems to believe the Fed that it will cut rates once again. “The Fed has, through the course of the year, seen fit to lower the expected path of interest rates,” Mr. Powell said, adding “that’s one of the reasons why the outlook is still a favorable one, despite these crosswinds we’ve been facing.” Mr. Powell was quoted telling an audience in Zurich that the Fed will continue its path toward helping the economic expansion continue. The markets seem to believe he him as well.

How To Trade

The biggest question is how does one trade lower rates? The easiest and simplest answer is bond funds and ETFs which own longer-dated bond notes. This trade is much different from the one last year and the year before as the Fed was tightening rates. The Fed is clearing telegraphing that the economy could be slowing, and it wants to give it another jump by lowering rates again. The simplest way to profit from lower rates is to purchase the iShares Barclays Aggregate Bond Index Fund (AGG). The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. AGG is a great investment for broad exposure to investment grade bonds and not junk while paying very low management fees of .05% or 5 basis points to do so.

Chart Data by YCharts

(Source: YCharts)

When comparing why you should consider adding more allocation to AGG over the SPDR S&P 500 ETF (SPY), the above chart sums it up. The AGG simply diversifies your assets across all long-dated bonds so you don't have to guess at what sectors of bonds to purchase. Right now, the AGG is also paying a dividend yield of 2.72% over the past 12 months. We are entering an environment with interest rate and economic instability where it could pay to be over allocated to bonds.

Another way if you want more beta to interest rates lowering is from the iShares Barclays 20+Year Treasury ETF (TLT). The iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. This ETF will go up in value as rates drop. What I like about these type of ETFs is the ease of use, the low cost of .15% to own it, and other ways to generate more income such as sell covered calls against them as well. Already, year-to-date the TLT is +18.6% as of writing.

Chart Data by YCharts

(Source: YCharts)

As you can see, the TLT has been outperforming the SPY over the past year. As interest rates continue to decline and markets become volatile, investors will continue to seek safe haven assets like TLT and United States Treasuries. One could easily create a bond portfolio of AGG & TLT together to produce non-correlated returns to equities.

Risks To The Lower Interest Rate Trade

The key risk to the lower interest rate trade is higher interest rates. Global economies could rapidly grow or higher inflation could grow, causing these bond funds to lose value. I really can't see a risk like this playing out where the investor would see massive losses due to rapid inflation. However, the Fed did raise rates just last year causing the long-end bond to correct and lose some value. The central bank directly affects short-term rates like those paid on bank deposit accounts and money-market funds, as well as rates on credit cards and many other types of loans. Prices for long-term bonds, by contrast, are influenced much more by inflation and inflationary expectations. If inflationary expectations were to grow, bonds in general are not a place to be. Nevertheless, inflation expectations remain very subdued due to a lack of wage and income growth.

In Conclusion

As the Federal Reserve bank continues to cut the fed funds rate to spur economic growth in the United States, bonds should continue their trend higher in prices. Investors should note the almost negative yields in Europe and have a plan for these type of fixed income conditions in the United States. As worldwide yields continue lower, the United States Treasuries are in demand vs buying a German 30-year bond at zero interest or slightly positive. One should not forget basic supply and demand. Demand for treasuries continues to increase as the Fed lowers rates due to the global market uncertainty. As investors seek safety globally, many global investors are turning to U.S. bonds. Investors can profit from this trend by purchasing aggregate bond funds like AGG or buying long-term treasury ETF's like TLT.

Disclosure: I am/we are long AGG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Ortner Capital consults clients whom own AGG and SPY. Please consult a professional on your own specific financial situation, as these are opinions of Mr. Josh Ortner, CTFA.