Posts tagged Interest Rate Trends
New fiscal quarter and same old bull market, or so it would appear. Which probably should not come as much of a surprise, given the veritable absence of anything markets would find new and newsworthy. The Fed pivot has come and gone, the trade war turned out in the end to be a paper tiger, economic growth is slowing everywhere but still positive. Corporate earnings will be weaker than previous quarters but probably not as weak as the dramatically ratcheted-down estimates of Wall Street analysts. The old parlor trick of outperforming a low bar is back in full force! Meanwhile, the Brexit extension to the extension to the extension (which you, dear reader, will recall we predicted back in January) was agreed to during the same week that we got to see a picture of an actual black hole, in space. No coincidence, surely, between those two events.
The Rule of 145 Days
So the good times continue…depending on your perspective. Year to date? Things are great. The S&P 500 is up nearly 16 percent (in price terms) since the start of 2019, which is one of the best starts to a calendar year, ever. Moreover, the intraday tempo of this rally has been relatively calm, with only a small number of instances where the index moved by more than one percent from open to close.
If you step back and take a wider view, though, the picture looks a bit different.
That 16 percent calendar year gain looks a bit different in the context of what preceded it: not just the sharp pullback of last autumn but a much longer trading period going back to January 2018. Here’s what has happened since the S&P 500 reached a then-all time high on January 26 of that year. There was a technical correction, followed by an arduous 145-day climb to a new record high (in August), then a bit more upward momentum to the record high of 2930 set on September 20. 135 days have passed since then, and now we are within striking distance of yet another record high (maybe, who knows, when the day count hits 145 again).
What this means in actual performance terms is that the S&P 500, as of yesterday’s close, had gained a grand total of 0.5 percent from that January 26, 2018 peak. That’s cumulative, not annualized. Zero point five percent is not the stuff of a robust bull. Arguably, this sixteen month period represents a distinct phase of the great bull market that started in 2009: a phase we would term “wait-and-see.” The previous phase was the exceedingly non-volatile stretch from November 2016 to January 2018 (which phase certainly qualified for the moniker “robust”), and before that was the Mid-Decade Pause (another wait-and-see period) that came on the heels of the Fed’s ending its last quantitative easing program in 2014 and persisted through summer 2016.
That 2014-16 period may be instructive. Below we extend that same S&P 500 chart shown above to encompass a longer time period, where this bull market’s distinct phases are evident.
Of course, and contrary to our tongue-in-cheek section heading above, there is no such thing as a “rule of 145 days.” But it does feel like we might be getting close to the end of this particular phase of the bull as the market closes in on a new record high. The question, as always, is what comes next. Recall that in 2016 there was not much in the way of a compelling case to make that would have predicted the bull run of 2017. The bond market for much of this year has been suggesting that slower times are ahead. But the tea leaves, as always, are subject to multiple interpretations.
The bond market has been an active place of late. The Fed’s monetary policy pivot back in January (and an even more dovish position in March), a tempered outlook on global economic growth and related concerns have sparked a broad-based bond rally, with falling yields across most fixed income asset classes. We have been getting a number of questions from our clients about how these dynamics affect the returns they are seeing in the fixed income securities in their portfolios. So here are some key things to keep in mind when you are reviewing the bond portion of your portfolio.
It’s All In the Math
One question that comes up frequently is what drives relative performance between similar securities (e.g., governments or corporates) with different maturities. Consider, for example, the Treasury market. The chart below shows the relative yield trends of the 10-year Treasury note, a key benchmark for intermediate term bonds, and the 2-year note, a popular proxy for short term issues, so far this year.
Two things jump out in this chart. First, the spread between these two bonds is relatively tight. Currently just 18 basis points (0.18 percent) separate the 10-year and 2-year yields. The second thing is that the relative movement of each yield has been remarkably similar: when one goes up so does the other, and vice versa.
But when you look at the total return performance in your portfolio you will notice that they are not the same, or similar, at all. For example, the total return for the iShares 1-3 year Treasury ETF (SHY) for the year to date as of April 4 was 0.88 percent. The total return for the iShares 7-10 year Treasury ETF (IEF) was 2.15 percent. Big difference! What gives?
Fortunately, the answer is very simple: it’s all about the math. Bond pricing is entirely and completely driven by math. It’s all about the rate of interest and the magnitude & timing of a bond’s periodic interest and principal payments. The math works such that, for any incremental change in interest rates, the price of a longer-dated security will change by more than the price of a shorter-dated security. So, to use the example of the 2-year and the 10-year bonds in the above chart, the same decrease in the rate of interest will cause the longer-term price to appreciate by more than the shorter-term one. That’s why, all else being equal, bonds with longer maturities (or effective duration, which is a measure by which we compare the relative effect of interest rate changes) have outperformed ones with shorter durations this year.
A Bond’s Purpose
If you knew that interest rates were going to go down for a long time then, all else being equal, you would want to position your portfolio to capture the benefits of longer duration. Conversely, if your vision of the future is one of rising rates, then you are interested in shorter-dated securities as a way to reduce interest rate risk. Of course, nobody can ever know for certain which way rates are going to trend (think, for example, of the Fed’s complete U-turn between its December and January meetings). The answer – or our approach, in any case – is to maintain a range of short to intermediate duration exposures with an eye to mitigating the risk of a sudden jump in rates.
Ours is a fairly conservative approach for the simple reason that for our portfolios, the fixed income portion is where you go for safety, not for outperformance. Bonds are for stability (predictability of the size and timing of income streams) and for cushion against the risks to which other asset classes – primarily equities – are exposed. And it is those riskier asset classes – again, not bonds – where we actively seek growth through capital appreciation.
The total size of our fixed income allocation may change – higher or lower as a percentage of total portfolio assets depending on our overall market and economic outlook. But you won’t find us aggressively chasing returns through active duration management, because that is not why we have bonds in the first place.
It’s quite a world, this one we inhabit. Today is Brexit Day! Article 50 goes into effect at 11 pm Greenwich Mean Time…except, of course, that it doesn’t, because our esteemed and honourable Members of Parliament are still having an existential debate regarding what Brexit is all about (real time update: the debate is over, again, with no agreement, again). The Monty Python sketch about Silly Upper Class Twits comes to mind. But no matter! We have nothing more to say about Brexit other than commiserations for the 48 percent of the citizenry of the Isles who never wanted this farce in the first place. We are here to talk about one of the other surreal features of our present day Planet Earth. Negative interest rates are back, and they are back with a vengeance. Here’s a snapshot of the yield trend for the German 10-year Bund, the go-to safe haven asset for the European Union.
What Don’t We Know?
The German Bund’s fall back into negative rate Wonderland is, of course, just one part of a massive global rally in bonds. Last week we talked about the inversion of the US yield curve and what that may mean for fixed income and equity investors in the weeks and months ahead. Elsewhere in the world the same trend is playing out. Take, for example, New Zealand. The 10-year Kiwi, as the country’s government bonds are known, hit record low yields this week. Not “52 week low” or even “five year low” but actual record low. The Kiwi’s 10-year journey towards Wonderland (it has not yet gone through the looking glass to negative rates) is shown in the chart below.
The sharp rally in Kiwi prices (bond prices move inversely to their yields) has much to do with the effects of a China slowdown on economies in the Asia Pacific Region. It’s not the directional trend as much as the speed of this global bond rally that is surprising, however. After all, we have known for many months now that growth in China was slowing and that further potential negative risks lurked in the form of a worsening US-China trade environment. We knew this in September and December of last year, when the Fed pronounced a robust bill of health on the economy enabling future rate hikes. What was it, starting in January this year and snowballing through the first quarter, that caused first the Fed, then the ECB, and then pretty much everyone else to out-dove themselves? What do they know that we don’t?
Data Not There Yet
The right answer to that last question may well be…nothing. After all, the central banks aren’t directly responsible for the pace of this bond market rally. Traders are…and by traders we mean, of course, algorithm-driven bots primed to move whatever way the mass consciousness of the digital world seems to be going. Trading by Twitter. It is entirely possible that this rally is already overbought, with bond yields potentially set to return to less gloom-and-doom territory.
After all, the global economy is not in recession and the data still do not suggest it is heading towards one in the coming months. Here in the US we have one month of lousy job numbers and inflation still struggling to maintain a two percent range (the latest Core Personal Consumption Expenditure rate, released today, is 1.8 percent). Q1 GDP is expected to come in below two percent, but weak first quarters are not unusual. Not great, but not too bad. The IMF’s latest projection for real global GDP growth for 2019 is 3.5 percent – down from earlier projections but, again, still comfortably north of zero.
Postmodern Financial Theory
Yes, but what about the inverted yield curve we talked about last week? That hasn’t gone away, and it remains the most prescient harbinger of forthcoming recessions, based on past instances. Is there something different about fixed income markets now that possibly makes this indicator less useful than it once was? Well, yes actually. In no past recession, ever, was there the presence of unconventional monetary policy all around the world. No negative interest rates. These aren’t even supposed to exist according to the conventions of modern financial theory. A dollar today is worth more than a dollar tomorrow, and the rate of interest that expresses a future value in present value terms is positive – that’s why it is called the discount rate.
But we have negative interest rates today, in many parts of the world, and they have the effect of flattening curves in markets where rates are still positive (like the US). The real (inflation-adjusted) rate of return on a 10-year US Treasury note may be barely positive (as is the case today) but it is still a whole lot more attractive than actually paying the German government for the “privilege” of holding its 10-year debt in your portfolio. This is not normal – and it may well suggest that we should not be reading too many recessionary warnings into these tea leaves.
What to do, then? Well, this is Wonderland. Whatever emergent properties bubble out of the current soup of variables at play could go one way, and they could go the other way. Anyone who tells you they know which way that is, well, they probably also have a bridge to sell you. A little caution, without an undue reduction of exposure to growth, is how we have been positioning the portfolios under our discretion. That course of action still seems reasonable to us.
Well, the first quarter of 2019 is about to enter the history books, and it’s been an odd one. On so very many levels, only a couple of which will be the subjects of this commentary. To be specific: stocks and bonds. Here’s a little snapshot to get the discussion started – the performance of the S&P 500 against the 10-year Treasury yield since the start of the year.
Livin’ La Vida Loca
For an intermediate-term bond investor these are good times (bond prices go up when yields go down). For an equity investor these are very good times – the 2019 bull run by the S&P 500 is that index’s best calendar year start in 20 years. There are plenty of reasons, though, to doubt that the good times will continue indefinitely. Something’s going to give. The bond market suggests the economic slowdown that started in the second half of last year (mostly, to date, outside the US) is going to intensify both abroad and at home. The stock market’s take is that any slowdown will be one of those fabled “soft landings” that are a perennial balm to jittery nerves, and will be more than compensated by a dovish Fed willing to use any means available to avoid a repeat of last fall’s brief debacle in risk asset markets (on this point there is some interesting chatter circulating around financial circles to the effect that the equity market has become “too big to fail,” a piquant topic we will consider in closer detail in upcoming commentaries).
We have been staring at a flattening yield curve for many months already, but we can now dispense with the gerundive form of the adjective: “flattening” it was, “flat” it now is. The chart below shows the spread between the 10-year yield and the 1-year yield; these two maturities are separated by nine years and, now, about five basis points of yield.
Short term fixed rate bonds benefitted from the radical pivot the Fed made back in January when it took further rate hikes off the table (which pivot was formally ratified this past Wednesday when the infamous “dot plot” of FOMC members’ Fed funds rate projections confirmed a base case of no more hikes in 2019). But movement in the 10-year yield was more pronounced; remember that the 10-year was flirting with 3.25 percent last fall, a rate many observers felt would trigger major institutional moves (e.g. by pension funds and insurance companies) out of equities and back into fixed income). Now the 10-year is just above 2.5 percent. Treasuries are the safest of all safe havens, and there appears to be plenty of safe-seeking sentiment out there. The yield curve is ever so close to inverting. If it does, expect the prognostications about recession to go into overdrive (though we will restate what we have said many times on these pages, that evidential data in support of an imminent recession are not apparent to the naked eye).
What about equities? The simple price gain (excluding dividends) for the S&P 500 is more than 13 percent since the beginning of the year, within relatively easy striking distance of the 9/20/18 record high and more or less done with every major technical barrier left over from the October-December meltdown. “Pain trade” activity has been particularly helpful in extending the relief rally, as money that fled to the sidelines after December tries to play catch-up (sell low, buy high, the eternal plight of the investor unable to escape the pull of fear and greed).
The easy explanation for the stock market’s tailwind, the one that invariably is deployed to sum up any given day’s trading activity, is the aforementioned Fed pivot plus relaxed tensions in the US-China trade war. That may have been a sufficient way to characterize the relief rally back from last year’s losses, but we question how much more upside either of those factors alone can generate.
The Fed itself suggested, during Wednesday’s post-FOMC meeting data dump and press conference, that the economic situation seems more negative than thought in the wake of the December meeting. The central bank still appears to have little understanding of why inflation has remained so persistently low throughout the recovery, but finally seems to be tipping its hat towards the notion that secular stagnation (the phenomenon of lower growth at a more systemic, less cyclical level) may be at hand. This view would seem to be more in line with the view of the bond market than with that of equities.
As we said above – something’s gotta give. Will that “something” be a flat yield curve that tips into inversion? If so, what else gives? That will be something to watch as the second quarter gets underway.
Just a couple years ago, the notion of “secular stagnation” was a favorite topic of conversation in the tea salons of the chattering classes. Secular stagnation is the idea that structural forces are at play pushing the growth rate of the global economy ever farther away from what we call “historical norms” (which really means “average rates of growth since the end of the Second World War”). Former Treasury Secretary Lawrence Summers was a leading proponent of the secular stagnation theory, pointing to widespread evidence of reduced levels of business investment and subdued consumer demand. Secular stagnation offers a different explanation of economic performance than the usual ups and downs of the business cycle. It suggests that the very idea of “historical norms” is meaningless: the world, and the world’s economy, has changed in profound ways since the 1950s and the 1960s, and there is no point in benchmarking current trends off those prevailing sixty and seventy years ago.
Hit the Mute Button
Secular stagnation lost quite a bit of mojo in the immediate aftermath of the 2016 election and the brief infatuation with the “reflation-infrastructure” phenomenon that was supposed to happen when the incoming administration turned on the full force of corporate tax cuts and deregulation. Although the tax windfall did arguably give a momentary sugar high to GDP growth rates, it didn’t have much of a sustained effect on business spending levels. And it had absolutely no effect on inflation. The chart below shows the long term inflation trend (core inflation, excluding food and energy) along with the corresponding ten year Treasury yield. The data go back to 1990.
There are a couple noteworthy things about this chart. The first is that inflation really has been a non-factor in the US economy since the mid-1990s. Core inflation has not risen above three percent since 1996. Through up cycles and down cycles, inflation has been – to use the word that is now embedding itself into the working vocabulary of the Federal Reserve – muted. And of course, in the recovery that began in 2009 core inflation has never even come close to the three percent level it last flirted with at the height of the manic real estate boom of 2006.
The second thing to observe in the above chart is the subduing of long term interest rates. We have talked about this in recent weeks, but here we focus on the 10-year yield as a barometer of inflationary expectations. One plausible reason for the persistence of the low benchmark yield – even after the Fed stopped buying intermediate term bonds as part of its QE programs – is that bond markets bought into the structural nature of muted inflation long before the Fed did. When the FOMC’s January 30 communiqué seemed to make official the Fed’s view of lower-for-longer inflation, one can picture the bond market replying thus: Thanks for telling me what I already know.
Alvin Hansen Gets His Day
And with that, a long-dead economist may finally have his life’s work recognized in formal monetary policy. Alvin Hansen was the originator of the term “secular stagnation,” way back in 1938. That was a grim year. Six years after the peak of the Great Depression, monetary authorities gingerly attempted to tighten policy and prevent the recovering economy from overheating. Things went south quickly, and policymakers realized that the economy was still too fragile to withstand traditional medicine.
Hansen’s secular stagnation theory seemed on the money at the time. Fortunately for the country, if not for Hansen’s own posterity, the theory quickly went out the window when the economy reflated onto a war footing as the Second World War broke out. Now that’s an infrastructure-reflation event! And dormant the theory lay until resurrected by Dr. Summers et al in the mid-2010s. We may still be one or two FOMC meetings away from calling it the dominant interpretation of today’s economy. But barring some genuinely massive exogenous shock to reflate the economy, the pattern of core inflation suggests that “lower for longer” is indeed what the world is going to have to get used to.