Bond Market Perspectives | Week of October 20, 2014

posted 10/23/2014 in Investments

Highlights

  • Yields may remain low for evidence of any fallout or contagion to the U.S. economy; a stretch of stronger economic data or bolder action by overseas central banks are likely needed catalysts for higher yields.
  • The on-guard mentality in the bond market has pushed back timing for Federal Reserve interest rate hikes.
  • Although yields may stay pinned low for potential fallout from abroad, we still believe investors should stay on guard, with an emphasis on corporate sectors and a slight underweight to bonds.

Stay on Guard

The latest bout of risk aversion is keeping bond markets "on guard" for additional troubles and
negative economic fallout that may keep yields low, until proven otherwise by economic data or bold steps by some of the world's central banks. Europe remains on the brink of a recession and questions linger about the extent of the slowdown in China's economy. Along with slowing inflation in Europe, a stronger U.S. dollar, and lower energy costs, downward pressures on U.S. inflation may linger as well--and support bond prices in the process. Bonds may remain on guard, with prices range bound, through year-end 2014 and perhaps into 2015, waiting for potential contagion effects of dramatic economic slowing overseas. All of this suggests little impetus for yields to move significantly higher over the short term.

Bond yields may stay low even though the current move is extended by historical measure. As a
percentage of the peak in yields--to account for the low yield environment--the yield decline over the past year amounts to slightly more than a 20% decline [Figure 1]. And using the 0.8% year-to-date decline amounts to a 26% change. Such extended moves are rare, but quick turnarounds are also rare, with mid-2005 as an exception. This suggests yields may stay low over the near term until a positive catalyst sparks a reversal.

Figure 1 also shows that a decline of 20% by itself may not stop the decline in yields, and they could fall further. We believe a new, lower yield range may be taking shape as defined by a 2.0% and 2.3% 10-year Treasury yield. After twice failing to break below 2.3% over the third quarter of 2014, the 10-year pushed through this resistance following the latest growth scare and stopped ahead of the psychological 2.0% yield barrier, which provides the next resistance, even though the 10-year Treasury yield dipped as low as 1.86% on an intraday basis very briefly on Wednesday, October 15, 2014.

Liquidity Risks

That sharp dip to 1.86% served as a reminder of liquidity risks (the ease with which an investment
can be bought or sold). At the time, the drop to 1.86% amounted to a 0.34% yield change for the
day--the greatest daily change since fall 2008 and the financial crisis. Ultimately the move was
quickly reversed, but nonetheless grabbed investors' attention as such volatility is extremely rare for the Treasury market. The sharp move lower in yields was likely driven by large investors forced to cover short positions. That a presumably few, but large, trades could have such an impact raises questions about whether it could happen again. Treasury volume was well above average last week but reflects the breadth, although not necessarily the depth, of the market. 

Uncertainty over whether more offside investors may be forced to exit positions is another reason that yields may hold near recent lows.

Signs of an illiquid market were prevalent in corporate bonds markets. Both investment-grade and high-yield bonds saw the fewest trades since December of last year. According to FINRA trade reporting, both investment-grade and high-yield bonds witnessed trading levels commensurate with the year-end holiday season, far from normal trading levels. Dodd-Frank financial regulatory reform has discouraged bond dealers from holding bonds in inventory to facilitate trading. The reduced liquidity can exacerbate price swings in either direction. In 2013, poor liquidity fueled the rise in rates; the opposite is occurring in 2014.

Fed Expectations

The on-guard mentality in the bond market has pushed back timing of Federal Reserve (Fed) interest rate hikes. Rate hike expectations fell sharply last week as overseas growth fears and low
inflation--which will likely remain low following the recent decline in energy prices--prompted
investors to expect the Fed to stay on the sideline for most of 2015 or risk a global recession if it
raises interest rates too soon. Recent comments from Dallas Fed President Fisher, a noted inflation hawk and one who has disagreed with the Fed's easy monetary policy in the past, appeared to change his tune just over one week ago, suggesting that U.S. dollar strength and European economic weakness may cause the Fed to remain on hold for longer.

Staying Defensive

The investment challenge facing bond investors does not necessarily change, even with a greater
likelihood of yields staying near current lows. Across the bond market, inflation-adjusted, or real,
yields remain far below historical norms as a reflection of just how expensive bonds are [Figure 2].

Real yields do not take into account varying amounts of interest rate risk or default risk, which can influence overall yield levels. However, should the economy remain resilient, as it has during prior bouts of European growth fears, then the higher real yields of the corporate sector may provide bond investors better opportunity.

An allocation to high-quality bonds can still help protect against additional stock market declines,
but we continue to favor corporate sectors as a means to seek out better valuations.

Since the end of the global financial crisis, Europe re-entered recession once and did not pull the U.S. economy down with it. Bouts of European debt fears have contributed to Treasury strength but not a renewed recession in the United States. The preponderance of data suggest the U.S. economy will pass this latest growth scare, but yields may remain low in the meantime. On a positive note, the recent drop in gasoline prices should help support consumer spending and provide support to the economy. Although yields may stay pinned low for potential fallout from abroad, we still believe investors should stay on guard, with an emphasis on corporate sectors and a slight underweight to bonds.

IMPORTANT DISCLOSURES

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 indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment.

Corporate bonds are considered higher risk than government bonds but normally offer a higher
yield and are subject to market, interest rate, and credit risk, as well as additional risks based onthe quality of issuer coupon rate, price, yield, maturity, and redemption features.

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.
This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent
investment advisor, please note that LPL Financial is not an affiliate of and makes no
representation with respect to such entity.

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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.

The financial consultants of Wealth Management are registered representatives with and Securities are offered through LPL Financial. Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.

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