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Is the Bond Market Wrong?

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After the surprise election results in 2016, domestic markets experienced the “Trump Bump,” which entailed a traditional risk-on shift—investors bought stocks and sold bonds to prepare for the presumed good times ahead. Stock values and interest rates both shot higher in anticipation of a boost to both economic activity and inflation.

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Trump Bump to Trump Slump

However, after a few months of treading water early in the New Year, interest rates began a steady decline. The 10-year Treasury note dropped from 2.60 percent to 2.25 percent in just a few weeks.

This occurred despite an early increase in overnight rates by the Federal Open Market Committee (FOMC) and clear messaging that they are prepared to continue the upward march in rates as part of a gradual “normalization.” All the while, stock prices remained resilient and repeatedly bumped up against all-time highs.

Debates and Head-Scratching

The drop in long-term rates created a flattening of the treasury yield curve, something that typically occurs near the end of a Fed tightening cycle, as the economy begins to slow down.

This rate drop and curve flattening has triggered a healthy debate throughout the

investment industry. It appears the bond market is signaling that the economy isn’t going to be nearly as strong as the equity market is discounting.

Historically, a flattening yield curve has been a strong, early indicator of economic deceleration—so the divergence between stock prices and interest rates has unleashed some serious head-scratching.

Disagreement Abounds

As a further complication, the Fed Funds futures market—the bond market’s estimate of where overnight rates are headed—is substantially below the FOMC’s estimates for where they’re planning to move rates. The FOMC expects overnight rates (and money market rates) to head to 1.50 percent in 2017 and rise to 2.20 percent in 2018, which is good news for savers. However, the futures market is placing overnight rates at only 1.25 percent and 1.50 percent in 2017 and 2018.

It appears that the bond market currently disagrees with both the FOMC and the stock market on the strength of the economy and the path of rates, raising the question, “Is the bond market wrong?”

Countering the Contrarian View

At this point, our answer is “yes, we believe the bond market is wrong.”  While it’s usually not fruitful to bet against the bond market, we believe several factors are causing it to paint a contrarian (versus the stock market) picture at this time:

  1. Assumption that the new administration will not get any stimulus plans enacted
    The bond market appears to be responding to the president’s early challenges with enacting campaign promises.
  2. Global interest rates
    Global interest rates are still well below the U.S. The glut of excess savings from around the world is still chasing U.S. rates whenever they rise, making it difficult for our rates to rise as much as they might otherwise.
  3. Normalization cycle
    Bond investors around the world are assuming the current Fed normalization cycle will play out in a similar manner to how the entire global financial crisis cycle has unwound—much slower than anyone anticipated. They are betting against any “upside surprises” for the economy or inflation, and it’s been a very long time since we’ve had either.
  4. Extreme caution in rising rates
    The bond market believes the FOMC will exhibit extreme caution in edging rates higher because it fears rising rates will tip the economy back toward a slowdown.The bond markets are not signaling that an economic slowdown is eminent, but rather that rate normalization will not be possible at the pace indicated by the Fed and most forecasters.

Why we believe the bond markets are wrong:

  1. We believe the new administration will succeed in enacting tax cuts and infrastructure programs—both will involve compromise and delays, but they will ultimately be accomplished, and both should point toward higher rates.
  2. We believe the global savings glut is in the very early stages of abating, so the artificial “lid” on interest rates may be slowly dissipating.
  3. While the last decade has been one of extremely slow movements from the Fed, it appears wage pressure is building throughout our economy—a precursor to inflation. Economic momentum is turning upward in Europe as well. These trends will allow the Fed to push forward with rate normalization at the pace reflected in most forecasts.
  4. Interest rates are exceptionally and unsustainably low, particularly given that we are experiencing a modest global upturn. Even after the Fed’s projected upward adjustments, interest rates will still be exceptionally low—modestly higher rates are not a threat to the economy or a barrier to normalization. For these reasons, we believe the bond markets are not properly reflecting the most likely path for interest rates over the next two years. There are risks to this outlook, but the most likely outcome is an upward shift of roughly 1.00-1.50 percent over the next two years.

Mr. Kelley is managing director of fixed income at UMB and is responsible for overseeing the product development and management of the fixed income holdings for the Wealth Management division. Mr. Kelley earned a Master’s of Business Administration from Baker University in Kansas City.



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The Federal Reserve: How the play ends

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The unprecedented expansion of the Federal Reserve’s (Fed) balance sheet that has occurred via quantitative easing (QE) over the last few years has created anxiety over the challenges associated with normalizing the Fed’s investment holdings. Forecasts about how the Fed will shrink its balance sheet by “managing down” its portfolio, a process loosely referred to as the Fed Exit Plan, have ranged from moderate concern to outright panic.

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Recently, the Federal Reserve provided an ambiguous update on its QE3 program, with Chairman Ben Bernanke supporting ongoing stimulus efforts during his testimony at a Congressional hearing. That was followed later the same day with the Fed’s April meeting minutes showing some officials would like to begin slowing the program as early as next month.

Regardless of exact timing, if the Fed successfully orchestrates a relatively smooth transition out of QE and into a tightening phase, we believe:

  • The next two to three years of Gross Domestic Product GDP growth will be 2.0-2.5 percent and that interest rates will move to 2.5 percent in 2013 and 3.5 percent in 2014.
  • The Fed Exit period will be marked by bouts of short-term volatility, but over the longer cycle should not result in dramatic, uncontrolled spikes in interest rates.
  • This environment should be supportive of positive equity returns and will be punitive for fixed-income assets, especially longer-duration government bonds.

Click here to read my full perspective on the Fed Exit Plan.

 

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Mr. Kelley is managing director of fixed income at UMB and is responsible for overseeing the product development and management of the fixed income holdings for the Wealth Management division. Mr. Kelley earned a Master’s of Business Administration from Baker University in Kansas City.



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