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June market update: Economy improves, low rates

The U.S. economy continues to improve, rates remain low, long-term bond yields may rise.

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The U.S. economy is getting better. Manufacturing is holding up well, capital spending appears to be perking up, and unemployment is continuing to come down. All this means that the mid-cycle economic expansion continues, and with inflation low, there doesn't seem to be any reason for a big spike in interest rates.

Those are the key takeaways from our monthly market update with Lars Schuster, institutional portfolio manager with Fidelity’s Strategic Advisers, Inc., and Dirk Hofschire, senior vice president of asset allocation research.

Schuster: Interest rates continue to fall in the United States. Why?

Hofschire: You're absolutely right. It has been surprising to many people that interest rates have stayed low and actually gone lower this year. Thinking about what happened in the last half of 2013, the 10-year Treasury bond yield went from about 1.7% to about 3.0% by the end of the year. Many people thought that that meant more rate hikes and further bond troubles ahead. But as we discussed at the beginning of the year, my outlook was that a lot of what happened in 2013 was already priced into the yield curve at the start of 2014. I thought that the Fed tapering its quantitative easing, and a lot of the better news about the U.S. economy, was already pretty much priced into the higher rates. For 2014, I felt that for rates to go up a lot more, we had to have even better-than-expected news or more tightening from the Fed than people expected. We haven't gotten that. The Fed has been very clear that even though it's tapering its extraordinary easing, it’s not close to starting to hike interest rates.

During the first quarter, as I’ve discussed the last few months, the U.S. economy was pretty disappointing, mostly for weather-related reasons. So, as I look forward, I think the U.S. economy is getting better, manufacturing is holding up well, capital spending appears to be perking up, and unemployment continues to come down. All this means that the mid-cycle economic expansion continues, and with inflation low, there doesn't seem to be any reason for a big spike in interest rates—especially not above the yields that we saw at the beginning of the year.

Schuster: Does the broader global economy affect U.S. interest rates?

Hofschire: Yes, I add the global environment to the mix of reasons why interest rates have stayed so low this year. The global economy’s doing OK, but we're seeing very, very slow growth abroad. Europe is doing relatively well from a cyclical standpoint, but on a very slow trajectory. China is a more fast-growing economy, but it’s really been decelerating. China also has very low inflation, so Europe's actually worried about deflation now. China’s slowing demand has meant lower commodity prices across a lot of different products.

Looking at monetary policy abroad, interest rates remain very low, especially for advanced economies like the United States, Europe, and Japan—they’re all anchoring their short-term rates near zero. So, bond yields are really low everywhere. It's not just a U.S. phenomenon. When you look at U.S. government bond yields today, they're quite a bit higher than Germany, Japan, and many other advanced economies. So, there are plenty of global reasons why there’s been downward pressure on rates this year, and many of these things are probably not going away anytime soon.

Schuster: What's your outlook for the very near future?

Hofschire: I think we have to put this all in perspective, especially the interest-rate backdrop. I still think over the medium term, we’re going to see long-term bond yields start to go up. I think eventually over the next two or three years, they may start to settle out around the long-term equilibrium growth rate for the U.S. economy – which would suggest around 4% for the 10-year Treasury bond. But this settling out may take awhile, for the reasons that we've already discussed.

Thinking about it from a portfolio construction standpoint, it doesn't mean that bonds are necessarily facing big near-term losses and that there’s a huge absolute downside risk. But, looking around the world, there are still a lot of potential catalysts for a pickup of more stock market volatility at some point. Slowing in China is one key variable. Investment-grade bonds have tended to be negatively correlated with stocks, and that's a good thing from a portfolio diversification standpoint. Therefore, I think that there’s potential for markets to become more volatile, and that means investment-grade bonds may still have a good place in a portfolio.

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