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What The Bond Market Is Telling Us

What The Bond Market Is Telling Us

The bond market was aflutter when Ben Bernanke in his recent testimony to Congress hinted that a pause in Fed rate increases is a strong possibility. Maturities rallied across the board bringing the benchmark 10yr down to a yield just below 5%.

With all the rhetoric about an inverted curve, rising energy and commodity prices, a cooling housing market, etc., what are we to expect from the economy? Here’s what the bond market has to say…

The Fed’s diligent inflation fight is why the short end of the curve is up. However, it’s this very fight which investors believe has snuffed out long-term inflation. This is why long rates haven’t moved up in step with short rates. Rising short rates with flat long rates brings about the flat (and for a time inverted) yield curve. Expect this situation to continue for a while.

Treasury Inflation-Protected Securities or “TIPS” offer an inflation hedge to the extent they provide a real (as opposed to nominal) rate or return. Do they make sense for investors? Maybe. Comparing the spread on Treasuries and TIPS yields an expected rate of inflation between 2.5% and 2.75%. TIPS are the way to go if investors believe actual inflation will be at or above this demarcation range.

We’ve seen the spread between Treasury and corporate bonds narrow – a sign of investor optimism. Why the positive outlook? On the investment-grade side, strong corporate profitability and positive economic fundamentals have made investors more comfortable with the risk/return tradeoff over Treasuries. As for high-yield bonds, investors continue to chase increased yields in a relatively low-rate environment.

The Fed is watching housing closely. Existing home sales have slowed from their highs. The concern is it will negatively impact consumer spending and, in turn, economic growth. An orderly housing slowdown is something the Fed can live with. It’ll be interesting to see what happens if housing prices dip sharply. Don’t expect the latter scenario to happen (unless you live in a frothy, speculative market such as coastal CA or FL) as median income figures suggest housing remains affordable.

Japan seems to have shaken off its funk that began in the late 80’s.

Japan’s central bank has backed away from its accommodative policy stance as extremely low rates have been pushed aside for liquidity reductions and rate increases. Expect to see an impact to the U.S. bond market. Tighter monetary policy in Japan makes Japanese bonds more attractive to investors creating competition for U.S. bonds and downward pressure on the U.S. Dollar.

Clients of Apollo Wealth Management know we’ve never been big fans of emerging markets. Although they have their periods of attractive performance and play a role in portfolio diversification, they never seem to offer reward commensurate with risk. While the “BRIC” countries (Brazil, Russia, India and China) have hogged the spotlight, it’s important to assess the state of the entire market to understand an impact to U.S. bonds.

The concern here is no different than with Japan. An improved outlook for emerging market debt creates competition for U.S. bonds and downward pressure on the Dollar. So what’s the outlook?

Generally, economic fundamentals are good as incomes are up and debt is more manageable. Many countries show more robust growth, acceptable inflation and decreasing current account deficits. As a result, non-traditional buyers such as pension funds have found their way to emerging market debt.

We suspect the party is over. The sharp rise in bond prices have attracted so much attention that “hot money” is what will probably underlie much of any future returns. Improved fundamentals or not, there’s little chance that these bonds are attractive at these levels given the risk relative to the safety in U.S. bonds.

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