Bond Market Perspectives | Week of April 14, 2014
- The market-friendly overtures from the Fed may help keep bond yields in the current low range, but much of the good news from the Fed is already priced into the bond market.
- Investors may be more willing to downplay Fed news and refocus on economic data, which will ultimately drive the Fed's decisions.
- Breaking out of the yield range now will likely depend on improving economic data over the next several weeks.
Last week, minutes of the March Federal Reserve (Fed) meeting revealed a Fed that is not in a hurry to raise interest rates and helped bonds to a strong start for the second quarter of 2014. The minutes, which often provide insight into the Fed's thinking on monetary policy, including the timing of interest rate increases, seemingly contradicted its forecasts set forth at the conclusion of the March 19, 2014 meeting. The minutes suggested a go-slow approach regarding the start and timing of eventual interest rate hikes.
Although intended to improve transparency and offer greater insight, the Fed minutes inadvertently created mixed messages. In one key passage, some members expressed "concern that this component (of the projections) could be misconstrued as indicating a move by the Committee to a less accommodative reaction function." Additionally, the Fed noted "that the increase in the median projection overstated the shift in the projections." In essence, these passages provided a counterpoint balancing the members' more aggressive forecasts for the federal funds rate in 2015 and 2016. Bond prices rose and yields declined on this gentler approach from the Fed.
It is not the first time the Fed has changed its stance. In September 2013, the Fed decided not to
begin tapering, or reducing, bond purchases after discussing tapering from late spring through the
summer of 2013. Investors widely anticipated the Fed to announce a reduction in bond purchases in September 2013, but the Fed instead deferred. At the December 2013 meeting the Fed was expected not to start tapering due to the approach of typically illiquid, year-end bond markets and a change in leadership with incoming Fed Chair Janet Yellen, but the Fed modestly surprised with a $10 billion reduction in bond purchases. Fast forward to March 2014 and the latest set of Fed projections showed an increase in the average amount of rate hikes in both 2015 and 2016 but was subsequently downplayed with the release of the March 19, 2014 Fed minutes.
Taking Account of Good News
The market-friendly overtures from the Fed may help keep bond yields in the current low range, but much of the good news from the Fed is already priced into the bond market. Fed fund futures pricing indicates the bond market expects the fed funds target rate to be 1.75% at the end of 2016 (according to CBOT), a notable 0.5% below the average projection of Fed members.
The broad Barclays Aggregate Bond Index is now up 2.6% year to date through Monday, April 14,
2014 -- an annualized pace of nearly 10% -- which is not sustainable. Still-simmering Russia-Ukraine
tensions, a holiday-shortened week, and the prospects of more stock market volatility may help
support bond prices over the very near term; but longer-term investors should take note of the
favorable news already priced into the bond market.
The good news is evident in overseas government bond markets as well. Greece returned to the bond market for the first time with a successful five-year bond sale with a yield of under 5% despitecarrying a still-heavy debt burden. Ten-year government bond yields in Italy and Spain are at or near all-time record lows with current yields of 3.15% and 3.08%, not far above the current 10-year Treasury yield--and less than half of the peak yields seen 2011 and 2012. All three of these European countries have benefited from the anticipation of the European Central Bank (ECB) starting a Fed-like bond-purchase program, known as quantitative easing (QE). The benefits of an ECB QE program may be factored into current prices and yields.
Since the end of the financial crisis, the Fed has erred to the side of accommodative policy, so last week's news was not entirely surprising. Nonetheless, mixed messaging from the Fed has helped keep yields range bound since summer 2013 [Figure 1] and may continue to do so until economic data improve.
Turning to the Economy
Given the mixed messages, investors may be more willing to downplay Fed communications and
refocus on economic data, which will ultimately drive the Fed's decisions. Monday's
stronger-than-expected retail sales data provided a taste of that with yields moving modestly higher in response to the first signs of a snapback from weather-impacted data over the first quarter. More will be needed to convince the bond market, however. A break out of the yield range now will likely depend on the economic data, which will likely take a few more weeks to reveal the degree of any snapback from the adverse impact of winter weather over the first quarter of 2014. We expect the economic reports to show a lessening of the weather impact.
As we discussed in our Outlook 2014: The Investor's Almanac, a hand-off was likely to occur in 2014
from policymakers to economic forces as the driver of higher yields, and we believe that will still be the case. Treasury yields are now back near the bottom of their recent trading ranges and much of the good news about the Fed is likely priced in. In 2013, the Fed was the primary instigator of bond price swings with the economy growing at a sluggish pace for most of the year.
We believe there may be a role reversal in 2014, and the market-friendly Fed meeting minutes mean that bond investors may now place greater focus on the economy. As the economy improves, the Fed may follow suit, and the direction of bond prices and yields could become clearer.
In a potentially negative sign, the 30-year Treasury yield dipped below 3.5% last week -- a key
resistance barrier [Figure 2]. The 30-year Treasury was a leading indicator when the bond market
rebounded late in the summer of 2013, and a move below 3.5% may foreshadow economic weakness.
The ability of the 30-year Treasury yield to hold below this key threshold may usher in additional
bond market strength. We believe the 30-year may have benefited from geopolitical tensions and
equity volatility and await a break below 2.5% on the 10-year to signal the probability of additional bond price gains.
A lot of good news has been priced into global bond markets. A holiday-shortened week here in the United States, still-simmering Ukraine-Russia tensions, lingering stock market volatility, and a
dovish Fed may help support bond prices over the very near term. But longer-term investors should take note of the lack of opportunities in the bond market. A resumption of economic weakness will likely be needed to propel yields meaningfully lower, something we do not expect to occur. The bond market has priced in a more market-friendly Fed view, and many European government bonds have benefited from the prospects of potential quantitative easing from the European Central Bank in coming months. With the Barclays Aggregate Bond Index up 2.6% year to date and on pace to return nearly 10% for the year, we believe investors should take gains in areas of strength and maintain a cautious approach.
The opinions voiced in this material are for general information only and are not intended to
provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges.
Index performance is not indicative of the performance of any investment.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.
The Fed funds rate is the interest rate on loans by the Fed to banks to meet reserve requirements.
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