One thing that has completely surprised most economists is how low interest rates have become. Interest rates have been very low for a number of years, and yet they have still managed to go even lower.
When discussing interest rates I am referring specifically to the 10-year U.S. Treasury, which is commonly used as a benchmark for longer-term rates. Mortgage rates tend to correlate very closely with changes in the 10-year Treasury.
Short-term rates, which the Federal Reserve directly controls, are slightly above their all-time lows. This is because the Federal Reserve raised rates one-quarter percent late last year.
What is especially surprising about the current environment is that the economy is not experiencing a crisis or a recession. Typically during a financial crisis, as we experienced in 2008, there is a flight to safety. U.S. Treasuries are considered extremely safe based on the backing of the U.S. government, but are also very liquid in that they can be easily bought and sold in large quantities.
During the 2008 period yields on U.S. Treasuries dropped significantly because of their “safe haven” status. However, since then interest rates have still stayed at very low levels, even as the economy has recovered.
Recently interest rates have dropped even lower due to the uncertainty created by Britain voting to leave the European Union. While this action in Britain is not going to have a material impact on the U.S. economy, it is creating ramifications in the financial markets.
Because of the uncertainty in Europe, investors in that continent have been seeking the safety of government bonds. The yields in Germany and Switzerland for their 10-year bonds are actually negative, and in France the yield is just above 0.
With the dramatic fall in interest rates in Europe, that tends to make U.S. Treasuries look more attractive. That is the principal reason why the 10-year U.S.Treasury has hit a record low during the past week.
For a U.S. investor earning less than 1.5% per year on a U.S. Treasury when inflation is near 2% is not very attractive. However, for the European or Japanese investor who is looking at negative rates, U.S. Treasuries do provide a decent alternative.
What is likely to occur is that interest rates will remain at very low levels until there is greater clarity about what is going on in Europe. Even a stronger than expected employment number this past Friday had little impact on U.S. interest rates.
Investors should realize that U.S. Treasuries are not the only alternative when investing in bonds. For example, someone investing in a diversified bond fund, will be purchasing a combination of government and corporate bonds. Therefore, the yield will be somewhat higher than just an investment in U.S. Treasuries. Likewise, municipal bonds can still be a decent alternative for investors in higher tax brackets.
For a number of years most economists thought that interest rates were at a bottom, and would eventually rise. That has not happened, as rates have continued to fall. Of course at some point rates will rise, though no one knows exactly when that might be.
It is certainly conceivable in the short run that interest rates could go even lower, as we have seen in other countries. However, for an investor with a longer-term outlook, purchasing a Treasury that will have a yield lower than the expected inflation rate is not a very attractive option.
The current interest rate environment is highly unusual, especially for an economy that is not in a recession. Having some investments in bonds is still appropriate for most investors for diversification purposes. However, I would recommend staying away from long term bonds, which exhibit more price volatility when interest rates change.