At the December meeting, the Federal Reserve (the Fed) decided to reduce its purchases of Treasury and mortgage securities (a.k.a. quantitative easing/QE) beginning in January 2014. This answered the question of when the taper would begin, and the markets reacted predictably. Two questions remain, however: How long until the Fed completely winds down QE; and when will short rates begin to reflect the improving economy? We feel it may be sooner on the former and could be quite some time on the latter. In the meantime, we are faced with a robust equity rally, a slightly steeper yield curve and a slow, sub-par recovery. None of these are a surprise. What does this mean for fixed income investors? We will try to address this below.
If we look at the equity market as a gauge of market sentiment, it appears that the economic growth we are seeing is sufficient, and there is not a lot of concern about the effect of the taper. After a mild disappointment following the Fed’s no-taper decision in September, the equity market, as measured by the S&P 500 Index, rallied approximately 9% from its lows in early October to early December. After treading water for about a week awaiting the most recent Fed meeting, it rallied another 2% into year-end following the decision to taper. Given that the headlines on employment, industrial production and inflation were generally good (or at a minimum, not bad), this is as expected. The uncertainty over when the taper would begin is now behind us, and the data the Fed needed to see in order to make that decision have been satisfactory. While in the second half of 2013 we focused on the Fed’s data dependency regarding the taper, one could speculate that in order for the equity market to continue rising in 2014, it may become “data dependent.”
Most estimates have QE winding down by the end of 2014. Dallas Fed President, Richard Fisher, who has been an outspoken critic of QE, recently admitted that he argued for a $20 billion taper. This opens up the door to an accelerated shutdown of QE, although our base case remains a gradual taper throughout the year. Concurrent with the reduction in QE is an increase in forward guidance. Simply put, this is what we like to call “jaw-boning” as Fed officials become more explicitly emphatic in their stated resolve to keep the Fed Funds rate near zero for an extended period. Ironically, this coincides with a stronger assessment of future economic growth by the very same Fed officials. Historically, stronger growth has typically been followed by higher rates. If we look at the Fed’s own forecasts for the Fed Funds rate, we see homogeneity in the near-term forecast, but when we get to 2015 and especially 2016, we see a wide range of possible outcomes. In 2016, for example, estimates range from 0.5% to over 4%! If the higher estimates prove correct, there could be quite a bit of volatility in the Treasury and investment grade bond markets. We have examined the Fed’s poor forecasting record in past outlooks; therefore, we are not changing course based on these new, rosy long-term predictions.
In spite of the generally positive economic news on the surface, there are signs that the economy is still struggling to achieve exit velocity from the sub-par recovery we have experienced for the last five years. According to a posting on ZeroHedge.com, there has been an increasing divergence between Not Seasonally Adjusted (NSA) and Seasonally Adjusted (SA) economic releases. Specifically, they point out the divergence between the recent SA and NSA Durable Goods Orders which compared to recent years, has become quite wide. “[In] 2010 through 2012 [they] acted just as expected, with SA and NSA data almost identical, …the 2013 data…diverged…inexplicably over $2.2 billion….If the SA number was accurate, and in line with what the NSA number predicted, Durable Goods ex-transports would have declined by-0.5% instead of rising by 1.2%.”1 Discrepancies between numbers like these keep us wondering about the veracity of the data. We have written before on the less-than-believable economic releases (especially regarding inflation reporting) but have concluded that without a better alternative, the market seems to accept them prima facie as accurate. So, until we can prove otherwise, we will remain aware of—but are not quite convinced about—the accuracy of various bits of data. Therefore, we do not believe that short rates will rise in the near future, nor will long rates meaningfully break out to the upside.
Since the Fed announced their intention to taper, yields on longer-dated Treasuries have risen a bit to about 3% on the 10-year and nearly 4% on the 30-year. (It appears that the market had priced in the taper earlier in the year.) We have also seen yields rise on the 2- and 5-year notes as well, to recent highs. While this is somewhat expected, we anticipate that further rises in yields will be measured. First, the largest demand source is shrinking, albeit gradually. Second, we have continued to experience tepid economic growth and are not in danger of overheating any time soon. That being said, we should expect that returns may be low for investment grade bonds as low yields struggle to offset declining bond prices caused by rising rates. Looking at the Bank of America (BofA) Merrill Lynch indexes for various sectors of the bond market, we can see this clearly as the expected price change for a 1% move in underlying rates (duration) exceeds the annual yield even for short-dated investment grade bonds:
|
Index (Data as of 12/31/2013) |
Average Yield |
Average Effective Duration |
|
1.62% |
5.49 |
|
|
The BofA Merrill Lynch 1-3 Year U.S. Treasury & Agency Index |
0.41% |
1.89 |
|
The BofA Merrill Lynch U.S. Corporate Index |
3.35% |
6.53 |
|
The BofA Merrill Lynch 1-3 Year U.S. Corporate Index |
1.14% |
1.86 |
|
The BofA Merrill Lynch U.S. Cash Pay High Yield Index |
5.86% |
4.35 |
|
The BofA Merrill Lynch 1-3 Year U.S. Cash Pay High Yield Index |
4.76% |
1.64 |
Source: Bloomberg. Yields are measured to effective maturity date.
Although absolute yields are historically low in below-investment grade bonds, the relationship of yield to interest rate driven price risk (duration) is still very favorable, especially in the shorter maturities. While this example only looks at one of the two main variables in fixed income (interest rate exposure), it illustrates how skewed some markets have become relative to interest rate exposure and how little cushion there is to protect against rising rates. We think the Fed is very aware of this and will be very deliberate in withdrawing its support, lest they cause a 1994-type dislocation in the bond markets, where the interest rate on the 10-year Treasury rose 2.4% over the course of nine months.
We continue to sound like a broken record regarding our outlook and, in a perfect world, we would prefer a return to more traditional post World War II interest rate cycles. These were somewhat more predictable and shorter-lived, but since we cannot change the macro environment, we will deal with it as best we can. We believe we are still in the midst of a lengthy deleveraging cycle, given the very high levels of debt now held on central banks’ balance sheets. This, combined with the concurrent circumscribed government spending, and in some cases outright austerity, may act as a headwind to economic growth for quite some time. This will most likely cause interest rates and reported inflation to slowly rise, as the velocity of money remains subdued. While yields on Treasuries will ebb and flow generally higher over time, we do not see a situation where interest rates rise high enough to choke off this sluggish recovery anytime soon. One necessary precursor to this would be a draining of excess bank reserves held at the Fed; an area definitely worth watching.
We will continue to emphasize short dated non-investment grade bonds while adding to our convertible exposure during equity market corrections. We will also add attractively priced longer-dated bonds with acceptable interest rate risk as opportunities present themselves. Having a good cash position is also a deliberate strategic move that allows us to act quickly when short-lived corrections present us with attractive opportunities. Longer term, we look forward to a time when investment grade bonds will present attractive investments. As always, we thank you for your continued support and will continue managing the major risks we see while endeavoring to take advantage of opportunities as they arise.
Let’s hope that calmer markets prevail in 2014 and once again thank you for your confidence in us.
Tyler Durden, “November Durable Goods Jump, Driven By Abnormal Seasonal Adjustments” submitted on 12/24/2013
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Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
The BofA Merrill Lynch U.S. Treasury & Agency Index tracks the performance of U.S. dollar denominated U.S. Treasury and non-subordinated U.S. agency debt issued in the U.S. domestic market.
The BofA Merrill Lynch 1-3 Year U.S. Treasury & Agency Index is a subset of The BofA Merrill Lynch U.S. Treasury & Agency Index including all securities with a remaining term to final maturity less than 3 years.
The BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
The BofA Merrill Lynch 1-3 Year U.S. Corporate Index is a subset of The BofA Merrill Lynch U.S. Corporate Index including all securities with a remaining term to final maturity less than 3 years.
The BofA Merrill Lynch U.S. Cash Pay High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.
The BofA Merrill Lynch 1-3 Year U.S. Cash Pay High Yield Index is a subset of The BofA Merrill Lynch U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 3 years.
The S&P 500 Index is an unmanaged index, which is widely regarded as the standard for measuring U.S. stock market performance. It represents the 500 most widely held U.S. publicly traded companies.
One cannot invest directly in an index.
Velocity of money is the rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time.
Duration is a measurement of the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.
© Osterweis Capital Management
© Osterweis Capital Management
