Nothing Happens in June - The Truth About Bonds - Part 2

Nothing Happens in June - The Truth About Bonds - Part 2

[caption id="attachment_437" align="alignleft" width="150"]John G. Finley, CFA John G. Finley, CFA[/caption]

In Part 1, we looked at some of the response to the 10-year Treasury bond yield increased from 2.19% on June 18th to 2.73% on June 25th. We will conclude with an evaluation of this change and how it affects us.

Let’s take a moment to review some economics. We can think of interest rates as the price of money, and, like any price, it is determined by supply and demand. The Fed controls one interest rate, the overnight borrowing rate between banks called the federal funds rate. They have maintained this rate at near zero for over three years. Because longer maturity interest rates can be thought of as simply a series of future shorter rates, the fed funds rate has a theoretical influence on longer rates, even though supply and demand from market participants (i.e., bond trading) actually determines longer rates from moment to moment.

Has the bond market overreacted to the Fed’s recent pronouncements? There is some reason to think so, especially at the short end of the treasury yield curve (maturities under 5 year). The current shape of the yield curve suggests that future short term rates might be too high, especially if the Fed keeps the fed funds rate near zero into 2015 as they have said.

Bearing in mind that forecasting interest rates is just as difficult as forecasting stock prices, what if we’re wrong about the “proper” pace of rising future interest rates? What if they continue to rise faster and more persistently from here? What if the Fed starts raising short-term interest rates well before 2015? That would most likely mean that one of two things is happening: (1) inflation has suddenly and unexpectedly spiked higher, or (2) the U.S. economy has suddenly started growing at a dramatically higher pace.

High inflation is unlikely anytime soon, given that the U.S. and most other developed economies are actually experiencing disinflation currently. Commodity prices have been falling (except pork bellies), industrial capacity is relatively high, workers have no power to demand higher wages and companies have little power to raise prices to their customers. The Fed is probably more worried about deflation right now, with inflation currently running below their target of 2%.

As for the economy overheating, first quarter 2013 real GDP was recently revised downward from 2.4% to 1.8% and there remain many economic and political headwinds in the U.S. While there are some bright spots such as new home sales, retail auto sales and durable goods orders, and the May non-farm payroll number announced on July 5th surprised on the upside slightly, few, if any, market observers think that the economy is in any danger of overheating anytime soon.

Undoubtedly, some of the volatility we are seeing in the markets seems to be related to what is called a “re-pricing of risk.” Investors must start getting used to the idea that the many years of central bank support to developed economies will eventually come to an end, to be replaced by old-fashioned fundamental analysis. In other words, can the world’s developed countries “stand on their own two feet” when it comes to sustainable long-term economic growth once central bank’s supportive policies are removed? Only time will tell, of course, but investors must not lose sight of the fact that, while markets in the short-term can often exhibit volatility, investing is a long-term proposition.

Warren Buffett, a perpetual cheerleader for American business, wrote in this year’s annual letter to Berkshire Hathaway shareholders: “America has faced the unknown since 1776…American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor.”2 In other words, don’t let the ever present short-term uncertainties take your focus off your long-term investment goals.

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