The “Unfortunate” Truth About the Bond Market?By Bob Andres | Aug 16, 2014
During the past four years, we investors have been inundated by financial commentators, strategists, economists and equity gurus prognosticating the coming collapse of the bond market. I can say with confidence that they have been woefully wrong during this period – I can also say with confidence that if they keep saying it, they will eventually get it right. These negative views on interest rates gained momentum in August of 2010 when Jeremy Siegel and Jeremy Schwartz authored, “The Bond Bubble and the Case for Equities.” I suggest that investors would have been far better served if the article were simply entitled, “The Case for Equities.”
Throughout this four year period, the consensus opinion was that interest rates were artificially low and needed to be higher. However, this view failed to recognize that the conditions, which initially caused the Fed to ease and maintain low rates, were still in play. Of course, interest rates were artificially low. Low rates were necessary to accomplish Fed policy: enabling equity prices to rise above intrinsic value— increasing the wealth effect and promoting economic growth. Ironically, the yield on the 10-year Treasury remains lower today than when the good professor made his declaration of 2010. Today, this yield is significantly lower than the consensus forecast made this past January.
I have been a proponent of the bond market throughout the entire period in question. I have not been alone in my views but certainly in the minority. I am also on record saying that many bond products would outperform equities in 2014.
Are we at an inflection point? Are low interest rates a thing of the past?
Any discussion involving the direction of interest rates needs to initially identify and then provide analysis of those factors that influence interest rate movements. There are many factors that influence the level of interest rates, but they vary in their importance. What follows is an attempt to highlight the key factors in this process.
· Fed Rate Policy. The Fed announced in mid-July that it generally agreed to end its bond-buying program, known as QE3, this October. A decision to increase the Fed Funds rate sometime later will be dependent on the Committee’s evolving assessments of actual and expected progress toward their stated objectives of price stability and employment growth. The Fed is faced with a serious conundrum. If they raise rates too aggressively, they have the potential to abort any economic expansion. However, raising rates too late will possibly stoke inflation and other risk asset bubbles.
· Unwinding Quantitative Easing. Risk assets and the wealth effect that benefited from artificially low interest rates may well come under pressure as the support system is reversed, particularly at a time when equity valuations are already elevated. The S&P corrected some 17% and 21% with the completion of QE1 and QE2 in 2010 and 2011 respectively. A repeat of such a pullback in equities would be supportive of the bond market.
· Is the U.S. economy itself at an inflection point? GDP growth since the onset of the “Great Recession” has been moderate at best and certainly schizophrenic. The turbulence found in quarterly GDP data has spread to and infected the bond and stock markets. The equity market is forecasting optimism and stronger economic growth while the bond market is almost suggesting that the Fed is “behind the curve” in not easing further. The economy needs to demonstrate some consistency moving forward. Today, there appears to be no identifiable driver of economic growth. The Q2 GDP announcement did provide some positive news, posting an advance of 4.0% and adjusting Q1 to a negative 2.1% from the previously reported negative 2.9%. While the increase in Q2 GDP reflected contributions from a wide swath of the economy, inventories contributed 1.66% comprising 41.5% of the headline figure.
Are inflation and inflationary expectations at an inflection point?
Obviously, employment and wages are on the Fed’s radar screens. Core CPI (excluding food and energy) of 1.5%, and PCE (an alternative method of gauging inflation) of 1.6% are both below the Fed’s upper bands. Productivity increased by 2.5%, a surprise to the consensus, which should help to lower any buildup in wage pressures and moderate inflation concerns. Wage pressures are limited, while employment data has been better than expected. Unit labor costs increased moderately at 0.6% rate in contrast to an 11.8% rise in Q1. These are not the kind of numbers that represent a base for rising production costs or inflationary pressures in the near term.
Fed GDP forecasts and the flattening of the yield curve. The flattening of the U.S. treasury yield curve has to be of some concern to the Fed. It has flattened significantly, particularly in front of the Fed’s tapering and the threat of an actual increase in the Fed Funds rate sometime in the next 12 months. Furthermore, the Fed has a horrible track record of forecasting economic growth. In June, they lowered their 2014 growth expectations from 2.9% to fall between 2.1% and 2.3%. They left unchanged their 2015 forecast at 3.0% – 3.2%. In every year since 2008, they have reduced their growth forecasts. Binyamin Appelbaum, in a New York Times article points out that, “In each year except 2012, the Fed… overestimated the strength of the economy in June of the forecast year.” The chief U.S. economist at Deutsche Bank, Joseph LaVorgna, points out that his research indicates that the 10-year Treasury yield has traded on average 31 basis points below the year-over-year trend of GDP since 2003. His analysis shows a correlation coefficient 0.71.
Before going further with this theme, I want to acknowledge that the correlation may not hold true this year. Maybe bond movements have become unhinged from GDP, or maybe tapering is playing a role I have not identified.
Please remember the 31 basis points is an average. Further, if above trend growth materialized over the second half of the year, inflationary expectations would, more than likely, push rates higher.
Having offered this potential scenario, let’s look at some numbers as if the correlation is maintained. Subtracting 31 basis points from the Fed’s current high-end forecast for 2014 of 2.3% we get a 10-year yield of 2.0%. Now, let’s assume we have above trend growth in quarters Q3 and Q4 of 4.0% respectively. This level of growth would then equate to 3.3% GDP and a 3.0% 10- year Treasury yield. Recent Cleveland Fed Data (7/31/14) suggests that the yield curve remains steep, as the mean slope has been 193 basis points since 2000. They project forward using past values of the spread that real GDP (inflation adjusted) will grow at about 1.5%. They further add that the influence of the past recession continues to push towards relatively low but steady growth rates.
Other Factors. There are a host of other factors that can influence the direction of interest rates. The Fed watches these factors but their influence is mostly transitory. They include: supply/demand factors, shifts in the yield curve, global interest rates, global and domestic savings rates, competition between equities and bonds for investment dollars, the global geopolitical environment and the concept of a flight to quality. Discussing the impact of these secondary factors could be an article by itself.
The consensus view is that the economy is growing above trend, causing inflation to move above the Fed’s comfort level and leading to substantially higher interest rates. I do not believe that current data supports the consensus view. Consistent economic growth tendency at levels associated with normal post-recessionary recoveries would allow me to reevaluate my view. Less volatile and higher trending growth would also reinforce my belief that the U.S. can avoid the path that has plagued the Japanese economy. If the converse is true—the U.S. economy growing at below trend—we will see lower rates as exemplified in Japan and currently in Western Europe.
The Fed’s balance sheet has grown to approximately $4.3 trillion. Reversing the easy money policy of the last seven years will not be a simple matter. The Fed has virtually no experience tightening from such a large base. They will have to be very cognoscente of how their unwinding policy impacts the $2.5 trillion in excess reserves the banks hold. Missteps could cause significant market volatility. Facing these issues, the Fed will likely move slowly and cautiously. They will also have to balance their desire to unwind with the knowledge that low rates have supported the mortgage market and other growth industries.
The bond market is not dead. There a lot of ways to make money in the bond market and it’s important to remember: Not All Bonds are Created Equal.