Until Magellan circumnavigated the globe in 1519, many folks believed that the world was flat. So, “one day,” figuratively speaking, Magellan and crew set off in an Easterly direction. Months later he showed back up from the West, and presto: the world was round. In fact, it stayed round until 2005, when Thomas Friedman famously informed us that it had become flat again, this time due to technology and globalization. While we are definitely taking some liberties with both Magellan’s global exploration and Friedman’s commentary on global developments, we are certainly noticing and feeling the “flattening” effect of a globally linked economy.
Most noticeably we are seeing and feeling this “flattening” effect in the cost of money, that is, in interest rates, or yields. Interest rates are moving lower and lower across the globe. You have certainly seen the interest you earn on your checking account disappear. Well, the same thing is happening with other types of loans, with the interest rates (or yields) that companies and governments pay on their debt falling.
Why is this happening? Central banks control short term interest rates, and when they worry about the slow pace of growth, they lower short term interest rates in order to stimulate lending by banks and borrowing by companies, with the goal of boosting the economy. Central banks are so concerned about global growth today that they are pushing interest rates to negative levels, forcing investors to actually pay interest (rather than earn it) on their bond investments. As we wrote last month, there are roughly $14 trillion dollars of sovereign debt at negative interest rates. The Bank of England, while not yet at negative, recently lowered its short-term interest rate to 0.25% as a result of England’s vote to leave the European Union. It created the lowest interest rate environment in the Bank’s 322-year history. It is, as we like to say, “a head scratcher.”
But that is only one form of “flattening.” The other is occurring between short-term and long-term rates. Consider the difference between the interest you earn on your checking account and the interest you earn on a 10-year CD, or between the cost of a 10-year and a 30-year mortgage. These differences are getting smaller and smaller as well. This condition, where the difference between short-term and long-term rates is small, and getting smaller, is called “curve flattening.” So what is happening to flatten bond yields? As Magellan did in the 1500’s, let’s explore.
The key to understanding this is to compare the rates (or yields) of US bonds to those of comparable developed countries (this doesn’t include countries like Greece). For Japan, Germany, France, and Switzerland, 10-year yields are hovering around zero (if not negative) and have been in a downtrend. Investors in these bonds would earn nothing or even pay money to buy these bonds. The equivalent rate for the US is around 1.5%. It’s not much, but at least it’s something! This difference attracts investors from these other countries. Who wouldn’t prefer the relative safety of the US bond market, the US dollar, and the higher interest rate? So while the US economy continues to improve (and the Fed raises short-term rates), international investors continue to buy our longer-term bonds (and keep long-term rates low). This combination “flattens the curve.”
So where does this “flat” global economy leave us? Economic stimulus such as that announced by the Bank of England encourages banks to lend and businesses to borrow. While not without risk, this is a much better situation for an equity investor than for someone investing in bonds. This has continued to play out as US equity markets have reached new highs. While the breadth of global negative interest rates is unusual, we are still positive on our outlook for stable interest rates in the US as well as for our diversified portfolios. As you might expect, most of the gains we are currently experiencing are from rising asset prices rather than from interest income.