Robert Tipp is the chief investment strategist of PGIM Fixed Income, the $709 billion global fixed income asset manager within Prudential Financial. He expects the long end of the yield curve to stay low even as the Fed continues to hike rates. In this interview with Business Insider’s Sara Silverstein, Tipp explains why this will happen and the impact it will have on investors’ portfolios. Following is a transcript of the video.
Sara Silverstein: The Fed has been hiking rates and they’re planning to hike in the future, but you think that rates are gonna stay low for a long time? Can you help me understand?
Robert Tipp: Sure, yeah. It depends on which rates, and obviously the Fed is hiking short-term rates and they expect to raise them all the way up to and above 3.4% by 2020. So, short rates are going up. But the rates that really matter for bond investors are the intermediate to long-term rates. So what’s priced into the market is that their short rates are going to get very close to and eventually go above 3% and so in the interim, while they’re raising rates, if the scenario plays out, longer term fixed income securities, even treasuries, may end up outperforming cash. But the fact of the matter is, this is not unusual. Usually, by the time the Fed gets around to raising rates, people can see the economy is doing well, they’re looking through the cycle, and the rise in long-term rates is often mostly, if not almost entirely over. So, I think that’s what’s going on here and there’s a lot of fluctuation quarter to quarter. Just last September, the 10-year Treasury was at 2%. We’ve sold off a lot since then, a lot of things have changed, but now people may be too optimistic on the economy or on the risks to interest rates on the high side, and so, as we’ve seen over the last couple of weeks, when we went from 291 and now we’re into the 270’s on the ten-year, it may become more range-bound and we’re probably closer to the top end of the range than the bottom would be our guess.
Silverstein: And when you look at the reaction to the recent Fed rate hike, what did you learn from that?
Tipp: Sure. Well, it’s very interesting that since the meeting, I mean, basically long-term interest rates have gone straight down, and ultimately what kills an economic expansion is not old age, but it’s the Fed getting involved and raising interest rates too much and knocking some kind of a delicate situation over into recession. And obviously, we’re not at risk of that now, but there are other factors that are giving the market concerns. We’ve seen concerns in tech stocks, we’ve seen more macro concerns about the deficit pushing down the dollar and steepening the curve earlier this year, and more recently, we’ve seen a lot of concerns on trade. We have a new approach in DC, America first, and one where bargaining positions at the most extreme are put out first, and then things are modulated as we go along, and the markets are adjusting to that. But basically, we’ve seen rates come down since then, and I think this is part and parcel not only of the rate hike cycle where typically the long-term rates go up first, I think it also is in keeping with the roll off.
And that may be a little bit counterintuitive, but by the time the Fed gets around to letting their portfolio roll off, this is very important for the bond market, the impact of their not buying and reinvesting may already be in the market. And we’ve seen this before in reverse, and this is with quantitative easing of which we had three phases in the United States. We also had a massive program in Europe to judge by, and the European one is easiest in some respects because there’s just one. By the time they got around to announcing and telling everybody what they were gonna do and exactly how much and all of that, the 10-year Bund was at about five basis points. And within a month or two later, it had sold off to all the way above 1%. Right now, it’s at 50 basis points and we’re basically three years on. So it has spent most of the time since the announcement beginning of the QE higher than where it was at that time.
So the reverse of that is now they’re doing quantitative tightening out of Washington DC with the Federal Reserve and the FOMC and the New York Fed extricating their policy. But basically, we’re at the point where now they are forcing the market to buy what they would normally reinvest in. And this is particularly important now because the deficit is expanding. So the government is going from having a reasonably small deficit that was entirely financed by the Fed to having a much larger deficit and that is gonna get financed by the market. So people might think they have a bigger deficit, that is going to push up interest rates. On the margin, that pushes up treasuries a little bit versus other interest rates in the market, but it has other effects. Those effects are pulling liquidity out of other sectors, out of corporate bonds, out of structured products, out of high yield, and we’ve seen some giveback in those markets relative to treasuries, and then we’ve seen higher volatility in the stock market. It’s been more susceptible to these shocks in the last few months and that may be because these are bigger shocks, but it may be part and parcel of the regime. And when we think about quantitative easing, that liquidity getting pumped into the system, we had a very strong stock market with very low volatility. Now, basically, you’re going into quantitative tightening. So, you may have a slightly less buoyant stock market and more volatility and in the end, that makes people more balanced in their approach. It’s positive for bonds.
Silverstein: And if long-term rates stay low for a while, do you think valuations can stay as extended in the US as they have been?
Tipp: You know, the markets that we’re seeing here are reasonable value. Equities, the earnings are obviously much higher than people expected based on the tax rates, and that’s not a short-term boost that gets given back. And so, multiples relative to rates look reasonably fair, but you’re late in the cycle. I think this is a point where you’re seeing a pretty flat yield curve, but interest rates have moved up. You’re not at 130 on the 10-year note and if our supposition is correct that a close to 3% yield curve is actually high, I think it’s very important for investors to have balance in their portfolios, that this is the point where, as we’re seeing in recent months, you can have more equity volatility. You may actually have less progress on the equity side, and it’s important for investors to have that balance.
We haven’t talked about the non-government parts of the market. Although spreads on corporate credit and emerging markets and so on have come in a lot from 2016 and certainly from the recession, there are still good values. And so, for investors coming into a general market fixed-income investment, there are a lot of opportunities in sector allocation, in security selection and where we’re positioning on the yield credit curve to be able to, ideally, outperform, continue to outperform the indices over time, and so investors should get a decent return for their fixed income, probably — And our expectation would be higher than cash over the long run by some margin and would also to provide balance relative to the riskier parts of their portfolios, if not generally, at least in a downside recessionary-type scenario.
Silverstein: Because what are you most worried about when it comes to the markets on either side?
Tipp: Ultimately, I mean, we’re looking at all the obvious things in terms of trade and in terms of inflation to make sure we’re not missing something, but if our base case is correct, and this has been our view for a while, that the market is basically in a good phase. This is a healthy backdrop. People are traumatized by a lot of things that have happened in recent decades. Ah, there’s too much inflation. Ah, there was too much debt. We’re gonna have a recession, we’re worried about — When in fact, being invested at a strategic allocation in their equities and their high-risk assets and in their bonds, has been superior to say, being in cash, or to being below strategic allocations. And I think this is likely to be a very long cycle because of the cautious approach policy makers are taking and the lack of excesses that we’re seeing. And when you look at the statistics, what they show is that equity performance has been so strong that fixed income allocations are still below normal despite the inflows that you’ve seen there. So, my concern is that people get away from their strategic allocations, when in fact, that’s probably the most effective place to be here where they’re gonna get the balance and the most efficient return profile.
Silverstein: Great, and is there anything that you think that people are getting really wrong when they look at this macro picture and rates in general?
Tipp: I think the focus, and from a behavioral finance perspective, as you’re keen on — People, they wanna think if they focus on something and they solve the puzzle, they’re gonna make money and know what to do with their portfolios. And right now, the focus is really on capacity and inflation and the Fed. But already what we’re seeing is the demand for money from the private sector is slowing down, and that’s giving you the signal that long-term rates are probably a bit too high. And we saw that at the end of 2013 when we were in the zip code for rates. We’re seeing it now, and that’s a signal and we’ll have to keep an eye on that. That will probably near to the top end of the range than the bottom and this focus on overheating in the Fed may be very misguided.