What Recent Bond Market Volatility Means For Investors

volatile-marketThe volatility in bond yields and bond prices is another source of risk for the investor that is interested in bonds.

Unless you are an investor that just wants to buy and hold a bond to its maturity, the volatility that now exists in the bond market makes for greater uncertainty as to exactly what the total return on a bond investment might be.

The general view on the future of interest rates as I have been writing about in my posts for LearnBonds is that longer-term interest rates will rise over the next two years or so. As we have started on this journey in 2013, the volatility in the yields on longer-term bonds has increased substantially. Given the current policy environment, it is my view that volatility will be even greater in the future as the yields on the longer-term securities rise.

Hence, my view that the rise is longer-term interest rates over the next two years or so is going to be bumpy one…a risky one.

We have seen the genesis of this viewpoint over the past six- to nine-months.

The Federal Reserve’s effort to provide the financial markets with “forward guidance” is supposed to steady markets because the Federal Reserve is providing the markets with its “best guestimate” of the future course of interest rates. Therefore, since investors know what the Fed’s plans are, they can be confident about the future and adjust their portfolios to match this scenario.

But, that is not what happens!

Look at the performance of the yield on longer-term government bonds over the past twelve months.

Around this time last year the yield on the 10-year Treasury bond was about 1.60 percent. In early May this rate was still somewhere around this level although it had been as high as 2.00 percent in February and March of this year.

But, we have been on a roller coaster since then. By early June, the 10-year yield was at 2.50 percent. By the beginning of September the yield had risen to around 3.00 percent. By the end of October, the yield dropped back to 2.50 percent…and now it rests somewhere in the neighborhood of 2.75 percent.

The one factor that has contributed to the “steady” rise in long-term government securities over this time period has been the European factor. As I have written several times in these posts in LearnBonds, when European financial markets were experiencing disruptions four to five years ago, a large amount of risk-averse money fled Europe for the “safe-haven” of United States financial markets. This helped drive down US interest rates.

In March of this year, as things settled down in Europe, these funds began to flow back to the eurozone. As having these funds in the United States helped to drive interest rates lower in the US, the reverse flow of funds back to Europe cause yields in the US to rise. But, this was a steady flow and did not cause the volatility that was observed.

Now, European debt has seemingly become more stable than US Treasury debt! For more on this see “Washington Turns Bond Market On Its Head.”

The unsteady factor has been connected with the Federal Reserve System. Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, has attempted to make the actions of the Federal Reserve more open and transparent to the financial community. His apparent successor, Janet Yellen is also an advocate of openness and transparency.

This effort to transmit more information to the financial markets is not consistent with “classical” central banking. In fact, central bankers did not want too much information on the conduct of monetary policy going to the investment community because they believed that this would cause financial markets to become more volatile rather than less. The reason for this belief was that investors would come to focus on what the central bankers were saying rather than on what they were doing and this would cause more “discrete” jumps in financial market conditions.

For one thing, central bankers are no better at forecasting the future than any other group of forecasters. They are human, have incomplete information, and work with fallible models…just like other human beings. Case in point…how well did the Federal Reserve forecast the financial collapse of 2007 the subsequent Great Recession? Gives you a lot of confidence doesn’t it?

Now after several years of quantitative easing, the Federal Reserve has talked about reducing the amount of securities it purchases from the open market every month. It has also indicated that it expects interest rates to stay extremely low until 2015 or so.

Oh, by the way, the Federal Reserve thought that economic growth would be higher than it is now and the unemployment rate lower than it is now…for about four years. Good forecasting!

And, the current situation for investors? I believe that Michael Aneiro captured the current situation in his Barron’s Current Yield column this past week: “Waiting for Godot—and the Fed.”

I quote: “We may have finally reached a point where the Federal Reserve has absolutely nothing new to tell us about its bond-buying program, short of ending it. Yet financial markets CONTINUE TO HANG ON THE FED’S EVERY WORD.”

Aneiro continues “Parsing Fed publications last week achieved levels previously reserved for Talmudic interpretations….”

And, “bonds sold off as markets saw hints that the Fed might—just might—be more prepared to taper at its next two-day meeting, which starts December 17, if and only if incoming economic data between now and then warrant it.”

But, the incoming economic data will only “warrant it” if Federal Reserve officials “believe” that the data warrant it! Thus, we must wait and see what it is that the officials believe.

This is how “on edge” participants in the financial markets are before the Federal Reserve actually does some tapering!

I wonder what it is going to be like after the tapering begins. Will we get interpretations like this: “If bond purchases go from $45 billion to $43 billion next month should we sell all the bonds we have because the Federal Reserve is tightening up monetary policy so aggressively.”

If financial markets hang on the Fed’s every word, we will get rising levels of longer-term interest rates, but the swings around these rising levels may be much more extreme than we have seen over the past nine months. Unless you are going to buy and hold bonds until they mature, I believe that bond buyers will need to be prepared for quite a bumpy ride over the next two to three years.

About John Mason

John Mason

John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.


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