Bond Market Perspectives | Week of February 24, 2014
- A burgeoning divergence between Treasury yields and economic data suggests the bond market is looking forward to spring and a clearer read of the economic data free of weather distortions.
- The bond market is also acknowledging the Fed remains on a slow course to remove accommodation that is not adequately reflected in today's prices and yields.
The pace of economic growth is one of the primary drivers of bond yields, and a number of
weaker-than-expected economic data points have helped support high-quality bond prices in 2014.
The softer economic data have translated into downward revisions to first quarter economic growth forecasts after an acceleration over the second half of 2013. The harsh weather experienced in much of the country this winter is frequently cited as negatively impacting economic reports. Winter weather's impact has been evident across a variety of economic data releases over January and February.
The adverse impact of weather has been cited as one factor by many Federal Reserve (Fed) officials and most recently by Chair Yellen in comments to Congress. Additionally, a number of corporations including Ford, General Motors, Walmart, Ingersoll Rand, and CSX Corp. cited weather impacts in recent earnings reports. To be sure, a few economic reports were mixed independent of the impact of weather, including the January employment report (released in early February 2014), not shown in Figure 1. Conversely, details of other reports point to underlying strength. In any case, the uncertainty has helped keep high-quality bond yields relatively stable so far in 2014.
Yielding to Weather
The impact of weather and subsequent weaker-than-expected economic data is reflected in the
Citigroup Economic Surprise Index. A rising line indicates more economic reports are surprising to
the upside, reflecting greater strength, while a declining line represents softer data and possibly
weaker underlying growth. Since the economy is a primary driver of bond yields, the close
correlation between the pace of the economy and Treasury yields is, pun intended, no surprise
However, note the recent divergence between the Economic Surprise Index and the 10-year Treasury yield. Bond markets are forward looking, and the recent rise in yields signals weather exhaustion: the bond market is looking forward to spring, when a clearer read of the economic data is available free of weather distortions. Last week, bond yields closed unchanged despite a sharp drop in housing starts and other disappointing data. This signals bond investors are unwilling to push yields much lower given that some economic indicators, most recently the Markit Purchasing Managers' Index, continue to show underlying strength. Homebuilder company stocks have also exhibited strength, suggesting recent softness in housing data is expected to pass.
Yielding to Emerging Markets
Worries over emerging markets (EM) also helped support bond prices. Over the past three months,
EM concerns, as measured by credit default swaps (CDS) pricing, have been closely correlated with the path of Treasury yields. A rising CDS price index reflects fewer investors buying insurance to protect against losses, and vice versa. Last week, rising unrest in the Ukraine failed to push Treasury yields lower, even as EM CDS touched prior lows before rebounding late in the week [Figure 3] and through Monday, February 24, 2014. The bond market may be signaling that EM weakness is unlikely to impact the domestic economy or postpone a reduction in Fed bond purchases.
Yielding to the Fed
The Fed, along with the economy, is another key driver of bond yields and may best explain why
Treasury yields have been unable to fall meaningfully lower. The release of the January 28-29, 2014 Fed meeting minutes revealed that Fed officials viewed weakness in recent economic data as
weather-related and also did not expect EM weakness to impact the domestic economy or financial markets. Bond investors were left facing a Fed that remains intent on reducing bond purchases and ultimately raising interest rates in 2015. The Fed's message appears to slightly contradict bond market expectations that the Fed will wait longer to raise interest rates [Figure 4]. Although still a long way off, bond market pricing is expensive and very far away from valuations that are typically prevalent at the start of rate hikes.
Winter storm Pax in February is also likely to have had a negative impact on the economy that will
potentially be reflected in the release of February economic reports from now through mid-March.
The clouds surrounding economic data are unlikely to lift until clearer, less weather-distorted data
become available in early April, as March economic reports are released. In the meantime, yields
may remain range bound as defined by a 2.5% to 3.0% 10-year Treasury yield. However, we continue to see signs of underlying strength that we believe will ultimately work to push yields gradually upward once again. In addition, the Fed remains focused on its slow journey to an eventual interest rate hike and bond yields should rise to "price in" that eventuality.
Should economic data prove softness is more than just weather-related, bond prices and yields may remain in the current range for longer. If the Fed signals a more gradual approach to reducing bond purchases and a delay in the timing of an eventual rate hike, a similar outcome would be likely.
Absent that however, we still advocate a defensive posture in bond portfolios, with an emphasis on more credit sensitive sectors such as high-yield bonds and bank loans, and use year-to-date strength as a selling opportunity in high-quality bonds.
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. Past performance is no
guarantee of future results.
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.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely
payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed
principal value. However, the value of fund shares is not guaranteed and will fluctuate.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior
to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the
alternative minimum tax. Federally tax-free but other state and local taxes may apply.Stock and mutual fund investing involves risk including loss of principal.
The Citigroup Economic Surprise Index is an objective and quantitative measure of economic
news. It is defined as weighted historical standard deviations of data surprises (actual releases vs
Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that
economic releases have on balance beaten consensus. The index is calculated daily in a rolling
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing
sector. The PMI index is based on five major indicators: new orders, inventory levels, production,
supplier deliveries and the employment environment.
A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products
between parties. The buyer of a credit swap receives credit protection, whereas the seller of the
swap guarantees the credit worthiness of the product. By doing this, the risk of default is
transferred from the holder of the fixed income security to the seller of the swap.
High-yield/junk bonds are not investment-grade securities, involve substantial risks, and
generally should be part of the diversified portfolio of sophisticated investors.
Bank loans are loans issued by below investment-grade companies for short-term funding
purposes with higher yield than short-term debt and involve market, interest rate, and credit risks.
Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the
expectations and the real economic data.
This research material has been prepared by LPL Financial.
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investment advisor, please note that LPL Financial is not an affiliate of and makes no
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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 referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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