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  • by Michael Turvey, CFP®, CMT

Interest Rates: The Missing Link to Volatility

While 2017 will likely be remembered as the year of low volatility, 2018 is shaping up to be the year where uncertainty around interest rates could produce some instability across capital markets.

As bond yields have steadily risen since September 2017, there’s much talk of rates “normalizing”. What does that mean exactly?

Most people probably assume it means moving away from the near-zero rate environment that resulted from the Great Recession of 2008-09, but looking below at the history of the 10-year Treasury yield going back to the 1950s, it’s difficult to define what period represents “normal”.

FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade. For illustrative purposes only.

With rates rising in the U.S., questions have also risen around whether we might see similar activity in the European Union. Currently, the European Central Bank (ECB) is still involved in a quantitative easing program, buying €30 billion in bonds each month. The ECB has previously committed to continuing this at least through the end of September, but after their last monthly meeting the language of their statement changed slightly, opening the door to potential rate increases as early as the second half of 2019. This is a significant development at a time when one-month U.S. Treasury bills are yielding more than 100 basis points (1%) higher than 10 year bonds in Germany.

Of course, a lot could happen to change the trajectory of rates in both the U.S. and Europe – an economic downturn or political turmoil for example. But, if growth stays steady and inflation starts to tick up, the expectation might be for the ECB to follow a similar path as the Federal Reserve in the U.S. And that could lead to some interesting developments for the euro-U.S. dollar relationship (EUR/USD).

Traditionally, higher interest rates push a currency upward, but that clearly has not been the case recently with the dollar. After bottoming in March 2015 and channeling sideways for two years, the EUR/USD broke out in April 2017 and has since advanced from below $1.10 to above $1.22. The strong euro has perplexed central bankers and pinned down inflation forecasts in the euro zone. Analysts see the EUR/USD moving towards $1.30, which would put it within reach of the strongest levels of the past 5 years.

For illustrative  purposes only.

The huge discrepancy between rates in the U.S. and Europe, as well as the EUR/USD relationship, affects other asset classes. Despite the fact that U.S. stocks have outperformed European stocks pretty consistently in recent years (see ratio chart below), investors continue to pour funds into international equities. According to the Investment Company Institute, since the beginning of 2010 investors have pulled a net $198 billion from domestic stock funds and put $1 trillion into international stock funds. Much of that flow is being driven by advisors, with potential rationale including higher dividend yields and cheaper price-to-earnings ratios. Furthermore, the declining dollar has boosted returns on foreign stocks for U.S. investors. In recent survey results, advisors have indicated that they are likely to continue allocating more to international equities.

For illustrative  purposes only.

Greater potential uncertainty around interest rates could produce more volatility in other asset classes like equities and currencies. Depending on how the Fed and ECB proceed, investors might have to get used to that volatility sticking around for a while.

To review some key economic events that the TD Ameritrade Institutional Strategy Desk will be following in upcoming months, click here to view the Economic Calendar*.

*Please note that by clicking the hyperlink provided you will enter an unaffiliated third-party website to access its products and services. The third-party site is governed by its posted privacy policy and terms of use, and the third party is solely responsible for the content and offerings on its website.

This material is designed for an investment professional audience, primarily Registered Investment Advisors (RIAs).

International investments involve special risks, including currency fluctuations and political and economic instability.

Past performance is not a guarantee of future results.

TD Ameritrade Institutional, Division of TD Ameritrade, Inc., member FINRA/ SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

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