Big Bad Bond Market

11/18/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.  But now I would like to come back as the bond market.  You can intimidate everybody.” – James Carville, political advisor

The biggest post-election news is the bond market.  Yields are up over one half of a percent to 2.25% on the 10-Year Treasury, which means bond prices fell.

The main reason behind the move in prices was higher inflation expectations. One of the main risks bond investors take into account is future inflation.  With President-Elect Trump’s big plans for infrastructure spending and tax cuts, it could mean greater money flowing in the system.  In addition, protectionist trade policy, if implemented, would also be inflationary for goods and services due to less competitiveness among companies.  In turn, this would lead to a larger federal budget deficit.  Traders and investors are pricing in the likelihood of these policies being passed by the Republican led Senate and House.  These policies go against many Congressional Republicans who spent the last several years threatening to shut down the government due to high budget deficits.

The breakeven inflation rate measures the difference between yield of nominal Treasury bonds and Treasury inflation-protected securities (TIPS).  It measures the inflation premium investors demand.  Inflation expectations were very low in the early part of 2016.  This measure increased sharply over the last few months and post-election.  This can be attributed to increasing wage pressures, oil prices bottoming, and talks of infrastructure spending by both candidates.

In the top half of the graph below, the price of the Barclays Long-Term Treasury Index is in teal blue.  Today, the bonds are trading at 108, which is in the lowest 6th percentile since 1990.  In other words, prices have been higher 94% of the time.  The green horizontal line is the average of the past 20 years. 

In the bottom half of the chart, the red area shows Treasury yields.  There has been a defined downtrend over decades.  Every few years it comes up to hit the diagonal downward blue dotted trend line when bond prices sell-off. 

While many worry if now is the time to sell bonds, others are asking if this is an opportune time to buy?

The Cleveland Fed publishes inflation expectations for the next ten years.  Per the website:

“The Federal Reserve Bank of Cleveland’s inflation expectations model uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations to calculate the expected inflation rate (CPI) over the next 30 years. The Cleveland Fed model is run every month on the date of the CPI release.  The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.75 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.”

In the big picture, what matters is whether there is secular change for inflation expectations.  If so, bond investors will demand a higher inflation premium for the risk of owning bonds.  The 35-year downtrend in interest rates may come under pressure, depending on how functional the government can be in its push for deregulation, fiscal spending, and tax cuts.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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