WASHINGTON. As we noted in our Thursday stock market wrap, stock averages, sectors and even individual stocks have a bad habit of reversing themselves on a dime. That makes for a nervous and difficult environment for the average investor. Surprisingly, more investors see that the bond outlook has gradually become more appealing.
2018’s bond market weirdness led us to read a variety of articles and studies analyzing this boring sector. The most puzzling thing about the bond outlook for at least the next two quarters involves bonds’ recent, downright odd stability in terms of yield.
You’d think that, with the Fed slowly but relentlessly hiking interest rates over the last year or two, bond yields would go up, up, up with each 0.25 percent hike. That’s indeed what they did for a time, using the bedrock 10-year Treasury bond interest rate as a benchmark.
From record interest rate lows at the beginning of the Fed’s current rate-hike regime, each 0.25 percent rate increase jacked the 10-year T-bond’s yield up roughly the same amount. In fact, the average secular increase in yield often jumped past the quarter percent raise before settling back down again, indicating that the bond vigilantes had finally risen from their nearly decade-long Great Recession sleep. The near-term bond outlook seemed to dim.
Indeed, the Fed’s Q1 interest rate hike suddenly scared the bejeebers out of bond traders, blasting the 10-year yield above the 3 percent mark for what seemed the first time in ages. (Which it actually was, relatively speaking.) For whatever reason – panic or greed among them – bond vigilantes and bond investors of all types panicked. They suddenly sold off bonds like there was no tomorrow. That led to the out-of-line 10-year bond yields we saw this past spring.
After the Fed announced its latest, widely-predicted 0.25 percent interest rate hike in June, bond yields briefly jumped. But they quickly returned to the roughly 2.8-2.9 percent yields we saw in mid-spring after the initial selling panic wore off.
What’s going on here? Has the bond outlook changed?
It’s a bit complicated, but we’ll try to sort it out for you here. A bit of patience might be required.
How the bond outlook and related bond prices work
For those not familiar with bonds, your average, everyday bond – Treasury, muni or corporate – starts out in life priced at $1,000 per bond (face value). At that price, it carries a fixed annual interest rate (or coupon) designating the interest the bond will pay out in semi-annual increments during its life. In practical terms, that life generally ranges from 5-30 years, sometimes even more, and sometimes less for short term “bonds” like Treasury bills (T-Bills).
But, from the moment a bond hits the market, its price will fluctuate daily, based on competitive bond yields in the bond market at large. A simple rule of thumb is this one:
- When prevailing interest rates go up, bond prices go down.
- When prevailing interest rates go down, bond prices go up.
Why this predictable formula is a useful predictor
This makes sense. Most bonds still carry a fixed interest rate, say 5 percent as an example. If a new bond gets issued with a 6 percent rate, then the only way that guy holding the 5 percent bond can sell it is to cut the price so his bond will net the eventual buyer an amount roughly equal to 6 percent.
This is because interest bearing investments have a strong tendency to conform to each day’s going rate.
It bears repeating that in a sinking interest rate climate, the opposite of our example is also true. If a new bond comes out offering 4 percent – a percentage point less than our 5 percent bond holder – he can sell his bond to a new owner for a premium, possibly more than he paid for it.
In the bond world, of course, there are additional complexities, such as the quality rating of a given bond or the time remaining before that bond matures – the point at which your capital is returned and the bond ceases to pay interest.
But our interest rate rule is the key item bond investors always need to be most aware of.
Other complexities involved
Macro-economic news also affects bondholders who, more than most investors, are very inflation adverse. If bondholders and bond vigilantes sense that inflation may take off, they tend to quickly react. They know inflation can erode their real rate of return by increasing prevailing interest rates and thus lowering the value of their bond holdings. That’s why they tend to sell off when inflation fears are on the increase.
And that’s what happened this spring. That’s when the early and very positive effects radiating out from the GOP’s tax cut law began to take effect. But at the moment, it appears that the ensuing bondholder panic was more than a bit overdone.
Why the bond outlook suddenly looks good again: Global Issues
Global expansion– i.e., expansion outside the U.S. – still remains fairly lame.Europe is expanding a bit again. But that’s after the Eurozone experienced a slump for roughly the first half of 2018. China in the meantime was making it tough to borrow money there, thus blunting their most recent expansion.
Trade sanctions and tariffs. Trump’s tough trade talk and trade sanction regime has further restrained international expansion. Nervous international companies and investors await the outcome of the President’s unexpectedly forceful moves. As expansion cools off a bit, pressure comes off inflation and thus off interest rates as well.
Why the bond outlook suddenly looks good again: The Fed
Federal Reserve interest rate policy.Right or wrong, the Fed apparently feels that the nation’s central bank must continue to hike interest rates back toward a pre-Great Recession “normal.” This also involves withdrawing all that Obama Era “free money” from the system by jettisoning the Fed’s grossly outsized portfolio of bonds and related instruments.
Most of these instruments were purchased during the Great Recession as a way to inject boatloads of money into a starving monetary system. Since this appears no longer necessary, the Fed’s getting rid of this stuff at a fairly brisk clip, which has the effect of soaking all that “free money” back up again.
Both the interest rate hikes and the bond inventory dumping tend to counteract any building inflationary expectations beyond the Fed’s oft-stated but rarely achieved 2 percent annual threshold. So far, so good, which is another reason why bond rates now tend to remain stable, even in the face of the Fed’s insistence on hiking rates every quarter. ZeroHedge posts a slightly different outlook on this. But bottom line: The economy remains stable. For now.
Why bond outlook suddenly looks good again: The personal level
Inflation fears are getting tamped back down.With that evil genie back in the bottle, at least at the moment.
Consumer confidence has begun to rise.Things seem in balance for now. Wages are finally on the increase, apparently without undue inflation pressure. And, at least for now, this means that vendors can finally start sneaking prices for their goods back up again after nearly a decade of virtual stagnation.
In other words, all’s right with the bond world, at least for now. And for that reason, bonds have suddenly and surprisingly regained at least some favor among investors. That’s particularly true for older, wealthier and understandably more economically conservative investors.
Any port in a storm
While outsized gains in tech stocks, for example, remain highly appealing for those still trying to repair damaged 401(k) plans devastated by the Great Recession and the Obama administration’s “fundamental transformation” of our economy into a reparations and redistribution regime.
But our current market craziness leads many of these investors to shun the risk of stocks and jump into bonds, bond funds, bond ETFs, utilities, preferred stocks and even REITs as a way to garner decent yields but without most of the risks associated with common stocks. This could all change. But for now, many conservative investors feel they can sleep better at night with more bonds and bond-like investments sleeping along with them in their portfolios.
Do note, however. No investment is perfect, nor is any investment perfectly stable. While we currently experience the unusual phenomenon of stable bonds in a rising interest rate environment, there could be a fly in the proverbial ointment. This particular fly is otherwise known as a “flattening yield curve.”
In a rising interest rate environment, buying a long-term bond (generally, a 30-year term from date of purchase) gradually becomes undesirable. That’s because the investor’s risk horizon is far enough out that something really bad could happen to the economy – like the Great Recession. For that reason, in an environment like the one we’re in, long-term bond prices should be declining pretty steadily. But both the 10-year and 30-year bond yields have gradually approached one another, meaning there’s little fear in the hearts of long-term bondholders.
This situation is known as a flattening yield curve. Few seem to care about this at the moment. But a flattening yield curve often indicates that something significant – positive or negative – will be happening soon to correct this rather unnatural situation.
For that reason, longer-term investments in fixed income instruments like bonds are riskier, as they could plunge rather nastily at a moment’s notice. Bonds and similiar instruments 10-year or less in duration are generally less vulnerable, since they’ll mature and be redeemed at par fairly soon, making them somewhat immune from a selling panic.
When we started writing this column Friday morning, stocks were predictably declining (again). The action made is seem like this was just another attempt by Mr. Market to negate the previous day’s smart move up in the averages. But as we close this article, the major averages have begun to slowly creep back up again.
This endless churning is all a bit much these days, primarily for aging Boomers. More of them are retiring. And many want to climb into that recently purchased RV and just light out for the territories. You know, before it’s too late. So why should they let the market torment them? They could be off having fun in the time remaining before their obligatory interview by St. Peter. But how can they do this if they’re managing and trading their own portfolio of stocks in this volatile market?
Good question, eh?
Here’s a good answer. Maybe it’s better to move most of that troublesome portfolio into bonds. And/or bond-like investments, and maybe a few shrewdly chosen ETFs. And then take off for parts unknown without a care in the world. (More or less.) At least for now. The buyer should always be aware.
(Article updated by the author from an earlier version to reflect more recent information.)
— Headline illustration: Wile E. Coyote swinging on a bungee cord, just like the stock market. (Screen grab of © Warner Bros. cartoon via unrestricted YouTube video. Satirical use to illustrate point.)