Yesterday, the equity market rallied after the strongest read of Consumer Confidence since 2000. Markets continued to climb on executive orders to ease regulations on energy industries, particularly coal and comments by Fed vice chair, Stanley Fischer, that he believed the Fed would hike only two more times, in 2017. Both the equity and bond markets saw this as dovish and responded accordingly.
As one might expect after dovish comments from a Fed official, long-term UST yields moved higher. Equity bulls and global investment strategists were quick to point this out. Some declared the steady rise to a 3.00% 10-year UST note was back on. Let’s put things into their proper perspective:
At the close of business on Monday March 27th, the 10-year UST yield stood at a hair over 2.37%. Following yesterday’s developments, the 10-year UST note yield rocketed to 2.42%, before ending the day at just over 2.41%. At the time of this writing, the 10-year UST yield stood at just over 2.37%. Some steady pace, huh?
After the close, several market participants exclaimed that the equity versus bond story was one of rotation. They were stating that it was just a matter of time before investors lost their fear of equities and pulled money from bonds. I guess they missed yesterday’s 5-year UST auction.
Yesterday’s auction of $34 billion 5-year notes experienced demand which was stronger than at the prior auction and the 10-auction average. Also, indirect bidder demand, which includes pensions, insurance companies and foreign central banks was the second strongest ever. Yes, ever! When you consider that most major central banks have been net sellers of U.S. Treasuries, in recent months, yesterday’s indirect bidder demand underscores just how strong demographic-driven actuarial demand truly is.
Anyone with even a modicum of fixed income market knowledge and experience understands that the robust appetite for bonds is driven not by fear, but by demographics. The average age of investors who hold the vast majority of investible wealth, in this Country, is advancing. Thanks to longer lifespans, by the time the next generation inherits assets from their Boomer parents, the Millennial Generation could be in its 40s or 50s. This augurs for another generation that could have a smaller allocation to equities than to what we old-timers have become accustomed during our careers. This is not blind opinion on my part. Do the math yourself. It is difficult to derive a scenario which is more likely than the one I have put forth. FYI: Hope is not a strategy.
One source of opinion which is different than mine are wealth management firm models. I have reviewed some, recently, and they all augur for surging inflation, re-normalizing of oil prices to above $60 or $70 a barrel and a 10-year UST yield which breaks through 3.00% and reaches, at least, 4.00%, over the next several years. These models and strategy outlooks are also often based on President Trump and the GOP batting 1.000 on pro-growth fiscal policies.
Pay attention to foreign sovereign debt yields, particularly the 10-year German bund yield. Since widening to 235 basis points, last December, the spread between the 10-year bund and 10-year UST note has narrowed to 203 basis points. However, this is still wider than the 175 basis point spread which existed, prior to Election Day. My belief is that, the UST note yield can only widen so much versus the 10-year German bund yield. If the euro currency exhibits strength, EMU inflation pressures, which have surged recently, could moderate. If European inflation moderates, the ECB could extend bond buying. This could hold down the 10-year German bund yield and, by extension, hold down the 10-year UST yield.
In my opinion, the reason that firms continue to put forth such aggressively optimistic forecasts is because they are necessary for their aggressive equity-centric models to perform well. Firms have pushed advisors to market and asset gather with firm models. If the bond market and oil prices don’t cooperate, the models will probably perform poorly. Without home run pro-growth fiscal policies, there is probably not a pickup in energy consumption to overcome the ever higher oil production, in the United States. Without home run fiscal policies, there probably isn’t enough inflation to drive the 10-year UST note yield through 3.00% for any length of time, if at all.
I would caution readers about becoming too complacent regarding a perpetually dovish Fed. Just this morning, Chicago Fed president, Charles Evans, who is considered to be the most dovish of the regional Federal Reserve Bank presidents, opined that, if fiscal policies emerged which threatened to cause inflation pressures to surge, the Fed would likely increase the pace of monetary policy tightening.
In my opinion, the airwaves and strategy reports are filled with disingenuous commentary designed to force market outcomes, self-fulfilling prophecies, if you will. My advice to readers is to consider multiple opinions, consider their source and motivations and decide the course of action which is best for you and/or your clients.
I would also advise readers to not get caught up in daily or even weekly volatility in areas of the markets which experience much algorithmic trading. Algorithms are programmed to react to data and media headlines for the purpose of short-term gains. However, they are no better than the quant who created them. Just look at what happened to the quant models used for MBS default and delinquency probabilities, during the housing bubble. Models tend to perform well when traditional correlations and probabilities, which have been baked in, perform as expected. Throw an unknown unknown into the mix and the models can be about as useful as a blacksmith on a spaceship.
About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.