Why Yields Will Head Even Lower
August 15, 2019
The US economy is in one of its longest periods of sustained growth in history, yet there’s little to no inflation. That’s a conundrum.
There are plenty of reasons for this, including changing consumer tastes for goods and services that are bringing further competition for sales and helping to drive prices lower overall. And with greater efficiencies from online sales and dramatically improving logistics, companies are slicing and dicing costs to keep and gain sales.
This is showing up in many of the faster-growth tech firms that are gaining sales and market penetration but losing money in the process. For example, Uber (UBER) has a massive market, but it still has negative operating margins. Even Amazon (AMZN), with its massive command of online retail, would be in a similar boat if it wasn’t for its Amazon Web Services cash machine.
Meanwhile, many input costs continue to fall, particularly in raw materials. The Bloomberg Commodities Index has fallen over the past five years by 38.34%. This means that, even with trade tariffs, raw goods are still down, reducing costs and inflation pressures.
And while wages are up—we’re seeing annualized gains around 3.20%—this isn’t showing up in pricing for goods and services.
This is also showing up in US wholesale prices. Over the past 12 months, the US Producer Price Index (PPI) dropped to 0.30%.
The key item to watch, which the Federal Reserve Bank’s Open Market Committee uses as its inflation barometer, is the core Personal Consumption Expenditure Index (PCE). The PCE measures pricing across all consumer spending and currently sits at 1.60%—well below FOMC’s stated 2.00% target.
US Core Personal Consumption Expenditure Index—Source: Bloomberg Finance, L.P.
The FOMC has been telling the markets that it will act in accordance with the PCE. But last year, it raised its target range for the federal funds rate four times, while inflation was nowhere to be found.
This is similar to 1995-1996 when the FOMC raised rates three times, only to reverse course quickly. That led the federal funds rate down and, with it, the bond market rallied 32.70% during that period. The S&P 500 returned 69.05%. And gold rallied 11.84%.
The FOMC has already cut its federal funds target rate in its most recent meeting, and I expect that it will cut further this year. And there’s plenty of activity aiding liquidity in the bond and money markets.
This all means lower yields. Year to date, the US benchmark Treasury yields have fallen from 2.60% to 1.73% for the one-year, 2.51% to 1.42% for the five-year and 2.69% to 1.52% for the 10-year.
Meanwhile, with low to negative inflation in Europe and Japan, the European Central Bank (ECB) and Bank of Japan (BOJ) have driven yields into negative territory. The result is that government bonds and corporate bonds are delivering negative yields.
This is creating an even better market for US corporate bonds, which are strongly in demand from US and global investors. And it shows in the returns generated from current yield and rising bond prices. My benchmark Bloomberg Barclays US Corporate High Yield Index is up 9.49% year to date, while the Bloomberg Barclays Municipal Index has returned 7.61% year to date.
Bloomberg Barclays High Yield Corporate & Municipal Total Return—Source: Bloomberg Finance, L.P.
Inflation will remain at bay, and lower interest rates will be the norm for a while. This sets up a series of investments that will continue to generate good income and gains to come.
The two sectors to focus on are high-yield corporate bonds and municipal bonds. The BlackRock Credit Allocation Income Trust (BTZ), with its great collection of corporate bonds, yields just shy of 6.00% and trades at a discount to its net assets by over 8.50%.
For municipals, look at the Nuveen Municipal Credit Income Fund (NZF), which sports a taxable equivalent yield of 7.46%. It trades at a discount of 3.83% to its net assets.
All My Best,
Editor, Dividend Digest & Profitable Investing
PS—Now that I’ve shown you how to profit from even lower interest rates, be sure to check out my Profitable Investing advisory for more of my market research and recommendations for further, safer growth and bigger, more reliable income.
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