Bond Market Perspectives | Week of May 5, 2014
- Several factors, led by short covering, pushed bond prices higher in the face of stronger economic data last week.
- Like the Greenspan conundrum of 2005, we expect an improving economy and the eventual onset of Fed rate hikes to gradually push bond yields higher.
The New Conundrum
In June 2004, the Federal Reserve (Fed) under Chairman Alan Greenspan began to raise interest
rates and proceeded to steadily increase the federal funds rate at subsequent meetings. Normally,
when the Fed raises the federal funds rate, an overnight lending rate, the impact ripples across the bond market in the form of higher intermediate- and long-term bond yields. But rather than rise, longer-term bond yields actually declined from mid-June 2004 through early 2005. During his
February 2005 semiannual testimony to Congress, a befuddled Greenspan described the bond
market's response of lower yields in the face of short-term interest rate hikes a "conundrum" -- one of the most well-known quotes from his tenure as Chairman. Greenspan had no clear explanation as to why bond yields moved lower despite the Fed's attempts to push them higher.
Last week, the bond market provided a new conundrum for investors. On May 1, a
stronger-than-expected Institute for Supply Management (ISM) manufacturing report for April along
with strong personal income and spending data for March resulted in higher bond prices and lower
yields. On May 2, a stronger-than-expected monthly employment report for April initially led to
lower bond prices, but weakness was quickly reversed, and long-term Treasury prices rose sharply
for a second consecutive day. Despite the first signs from top-tier indicators that the economy was indeed snapping back from weather-depressed performance during the first quarter of 2014, bond prices rose and yields declined -- price action that is commensurate with a weakening economy and not an improving one.
Bond market strength in the face of stronger economic data was counterintuitive, especially
considering it encourages the Fed to not only reduce bond purchases in 2014, but also proceed with raising interest rates over the second half of 2015.
The six factors below help explain bonds' strength in the face of improving economic data:
Short covering. Like stocks, investors can short-sell bonds to benefit from lower prices. When
prices do not fall, a buying scramble can follow as investors look to cover short positions to avoid
losses, and bond prices rise in response. The amount of short positions came close to an extreme
again in mid-April [Figure 1], and a continued reversal has helped bond prices rise and yields fall
over the past two weeks. While not always a driver, large futures positions, long or short, can be a catalyst for sharp market movements. Our January 28, 2014, Bond Market Perspectives discussed
how short-covering influenced the decline in yields to start 2014. A similar market theme may have played a role in last week's Treasury strength, which saw 10- and 30-year Treasury yields match or fall below their lowest levels of 2014.
Growth uncertainty. The first release of first quarter 2014 economic growth, which came out prior to the above-mentioned reports and increased at a meager 0.1%, was a weak data point that may have left bond investors wanting more proof of improvement before warranting higher yields. Although both the ISM and employment reports reflected strength, some of the underlying data of the monthly jobs report -- including a deceleration in hourly earnings -- may have rekindled doubts from first quarter growth and led to bond strength.
Low inflation. Inflation remains stubbornly below the Fed's objective of 2%, and absent an increase in March 2014, inflation has decreased steadily over the past two years [Figure 2]. Fading inflation, one of the primary threats to bond investing, can help support longer-term bond prices.
Fed doubts. Low inflation has two primary implications for Fed policy. First, it leads to
expectations that the Fed will wait longer to raise interest rates and helps support bond prices in the process. Second, persistent low inflation causes investors to question whether the Fed may raise the federal funds rate as high as its stated long-run forecast of 4%. Stubbornly low inflation may warrant a lower resting spot for short-term interest rates, which in turn may make current long-term bond yields attractive.
Shortage. The amount of top-quality, AAA-rated debt globally has decreased since the end of the
2008-2009 global financial crisis leaving investors chasing fewer high-quality assets.
Mortgage-backed securities (MBS) issuance has declined since 2008 and has slowed further over the past year as higher interest rates curtail residential loan originations. A number of European
governments have lost their AAA rating in response to heavy debt burdens and a double-dip
recession. Just last month, downgrades of Automatic Data Processing, Inc. left only three AAA-rated U.S. corporate bond issuers. Furthermore, yields on investment-grade corporate, high-yield, and emerging market debt have fallen sharply, reducing their attractiveness as an alternative to
Treasuries. Strength in European government bonds has also made Treasuries relatively more
attractive. For example, the yield advantage of the 10-year U.S. Treasury relative to comparable
German Bunds remains very close to a 10-year high of 1.2% [Figure 3]. Throw in Fed purchases and a slower pace of Treasury issuance due to a shrinking budget deficit, and the amount of high quality bonds is reduced further.
Ukraine and Russia. Finally, geopolitical conflict in Ukraine has prompted support for
high-quality assets such as Treasuries, especially as the weekend approached. Four of the past five weeks have witnessed stronger prices on both Thursday and Friday of each week. Global banking ties to Ukraine are very limited, which reduces the financial market's risk from the conflict, but it has still boosted demand for safe assets.
All of the above factors have played a role in year-to-date bond strength. We suspect that short
covering was particularly acute last week and was a primary driver of bond prices but acknowledge that bona fide high-quality bond buyers were also prevalent. In an over-the-counter market like the bond market, it is difficult to pin down the exact source of buying and selling at any given point in time. The service sector ISM release on Monday, May 5, 2014, was another sign of a bounce back from adverse weather, and we expect bond prices to weaken in response to stronger economic data.
Following Greenspan's conundrum comments in February 2005, Treasury yields remained range
bound for six months before yields began to increase from August 2005 through June 2006.
Additional rate hikes and an expanding economy combined to pressure the 10-year Treasury yield
higher by 1.2% over that time frame. Similarly, we believe Treasury yields will succumb to the
economic improvement we expect to materialize in coming months and break out of the range they have been in for the past five months.
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. 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.
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 priorto 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.
Short selling (also known as shorting or going short) is the practice of selling assets, usually
securities, that have been borrowed from a third party (usually a broker) with the intention of
buying identical assets back at a later date to return to the lender. The short seller hopes to profit
from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than the seller received on selling them.
An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's
capacity to meet its financial commitment on the obligation is extremely strong.
German Bund is a bond issued by Germany's federal government, or the German word for "bond."
Bunds are the German equivalent of U.S. Treasury bonds. The German government uses bunds to
finance its spending. Long-term bonds are the most widely issued, with billions of euros' worth
outstanding, and these come in 10- and 30-year durations.
Mortgage backed security (MBS) is a type of asset-backed security that is secured by a mortgage or
collection of mortgages. These securities must also be grouped in one of the top two ratings as
determined by an accredited credit rating agency, and usually pay periodic payments that are
similar to coupon payments. Furthermore, the mortgage must have originated from a regulated
and authorized financial institution.
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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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