These are strange days in the bond market. Never before have central banks influenced market conditions quite like this. Yes, central banks have influenced the bond market in the past through interest rate policy, but never before have central banks directly intervened in the bond markets to (dare we say it) manipulate interest rates.
Please don’t shout while they fiddle about
Alright, maybe manipulate is too strong of a word (maybe it isn’t). However, one of the reasons The Bank of Japan fired its so-called bazooka (which is just about out of ammo) last Friday in large part because Japan’s sovereign pension fund was increasing its equity holdings to 50%. To do this the pension fund has to sell bonds. The BOJ entered the market to ensure that Japan’s ultra-low interest rates remained ultra-low. At the time the BOJ’s action, the 10-year JGB was yielding about 0.46%. Heaven forbid if its yield rose to 0.50%. Fortunately for the Japanese economy the yield of the 10-year JGB fell to a stimulative 0.43%. Think about this. The BOJ had to make sure that long-term rates did not rise a few basis points in order to keep Japan from slipping into deflation. It is beyond us how anyone can look at Japan (with a 0.43% 10-year rate) and the Eurozone (with a 0.85% 10-year German Bund and a Spanish 10-year sovereign yield of 2.14%) and not understand that the economic structures are either broken or have at least changed.
To see a list of high yielding CDs go here.
In spite of all the evidence to the contrary, the popular position is that it is only a matter of time before conditions return to those with which we have all become accustomed. We wonder if there are people in Britain who are patiently awaiting the return of their upstart colonies or Egyptians who eagerly await the return of the pharaoh. The truth is the British Empire and Egyptian pharaohs are now confined to the pages of history. We fear that the Post-War Baby-boomer-led economy also belongs to the ages. Not everyone is waiting for deliverance. (5)
With a Rebel yell they cried more, more, more
It seems as though the bond market has figured out that the economy which existed for the past 60-plus years might have faded into history. An indication of this can be found in the behavior of U.S. Treasury prices in the wake of Fed asset purchase tapering. The Fed was purchasing the equivalent of all the new supply of U.S. Treasuries. It was believed that when the Fed stopped buying bonds, long-term Treasury yields would spike higher. As the Fed was not expected to taper asset purchases unless the economy was on stronger footing, there was supposed to be a fundamental reason for rising rates. However, something happened when the Fed began to taper asset purchases, long-term rates fell.
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The Fed announced tapering at the December 2013 FOMC meeting. The yield of the 10-year U.S. Treasury note began the year at 3.00%. It stands at about 2.33% today. What did the experts miss?
- Some investors were squeezed out by Fed buying. These were among investors who sought yield in other asset classes. When the Fed began to vacate longer-dated U.S. Treasuries, some of these buyers returned.
- Foreign sovereign debt yields plunged as cracks in economies became deeper and wider.
- Changes in the structure of the U.S. economy augur well for low structural inflation.
In each of these cases, experts were only looking at half the story. Instead of looking around at economic realities, experts held fast to looking at past performance to gauge potential future results. Many experts now believe that the supply of U.S. Treasuries might be insufficient to meet potential demand. Relatively high rates versus foreign sovereign interest rates have made U.S. Treasury debt more attractive. William O’Donnell, the head U.S. government bond strategist at RBS Securities Inc. told Bloomberg News:
“There may not be enough Treasuries to go around. We watched the Fed slow its purchases and yet rates are still falling.”
This is not surprising to Bond Squad. We made this observation many months ago.
Long-term rates respond to inflation pressures and/or inflation expectations. With the Fed out of the long-dated Treasuries game, the bond market should be accurately expressing inflation sentiments of market participants. It is apparent that bond market participants are not expecting an uptick in wage of inflation pressures. While the punditry and investment sales people continue to discuss economic and market cycles, bond market participants are focused on economic structure. They bond market is saying that, as the global economy is presently constructed, wage and inflation pressures should remain light for an extended period of time. In short: Things are different today.
Equity market participants continue to hang onto the old belief that a tightening of Fed policy portends a return to the old normal. The bond market believes that it marks move to a new normal. It is our opinion that instead of all rates moving higher, the first Fed Funds Rate hike will result in a flattening of the yield curve (if the market does not act pre-emptively. We also advise readers not to underestimate the impact of changing demographics on bond yields and long-term interest rates. A scenario is materializing in which the demand for income and capital preservation outstrips the supply of high-quality bonds. We do not believe that this is cyclical. Increased demand for bonds appears very structural. Boom goes the “Great Rotation” (out of bonds into stocks) theory, no matter how many pundits try to convince investors to rotate capital.
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By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC