When 2014 started, some Wall Street strategists predicted a continuing rise in interest rates as U.S. economic growth accelerated and the Federal Reserve (the “Fed”) reduced its monthly stimulus. Instead, it has been a one-way street in government bond markets as they continued to deliver low yields at higher prices. In August, the yield on the benchmark U.S. 10-year Note fell to 2.3%, back down to June 2013 levels. The 10-year German Bund yield settled at 0.9%, which is its lowest level on record. There seems to be little in the foreseeable future to reverse these trends and most investors are now trying to figure out what comes next for the bond market.
It is understandable that yields on German bonds are at an all-time low. Euro-zone growth and inflation are at very low levels. Geopolitical risk is running high in the Middle East and Ukraine, which has led to a flight into historically safe-haven bonds. In addition, the European Central Bank recently announced another round of interest rate cuts, reducing the benchmark and deposit rates by 0.10%, to 0.05% and minus 0.20%, respectively, in order to stimulate the economy.
Normally, we would expect the U.S. Treasury market to set the tone for global bond yields. Investors, however, seem to be focused on relative rather than absolute value. Falling German yields, as well as those of many euro-zone countries, make U.S. bonds look cheap, and this is driving U.S. yields lower. (Typically we would expect to see rates rise, reflecting the continued growth in the U.S. economy). The longer U.S. inflation remains close to the Fed’s 2% target, the more risk there is of upward pressure on rates. In our view this risk is underpriced in the market today. Demand for U.S. Treasuries appears to be creating a distorted yield environment that is not reflective of the following three factors:
- Compared to weakness in the euro-zone, the U.S. economy is quite robust. U.S. gross domestic product (GDP) for the second quarter was revised up to an annual rate of 4.6% from the previously reported 4.0%. Increased business spending on new equipment and buildings helped boost the economy last quarter, along with stronger household spending on durable goods like automobiles. In addition, the Conference Board’s Consumer Confidence Index rose to 92.4% in August, the highest since October 2007, from 90.3% in July. Additionally, forecasting firm Macroeconomic Advisors recently revised its forecast for third quarter GDP growth to 3.4% from 3.1%.
- The U.S. unemployment rate has been falling. The rate fell to 6.1% in August from 7.3% a year ago. The decline has surprised Fed officials, who expected in December 2013 that it would fall to 6.3% by the end of 2014. In comparison, the euro-zone’s jobless rate was 11.5% in July. Since the U.S. economy has continued to add about 200,000 jobs a month on average lately, we believe that there will likely be a continued decline in the unemployment rate.
- Inflation is modest but could be on the rise. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures Index, rose 1.6% in July from 12 months before. Another measure, the Consumer Price Index, rose 1.7% in August from a year ago. Both indices are still below the Fed’s 2% target, but as the labor market continues to improve more quickly than expected, the likelihood of inflation running persistently below 2% has diminished.
The question remains: When will the Fed raise rates? In their recently updated economic forecasts, Fed officials now expect that the unemployment rate will be between 5.9% and 6.0% for this year, versus the 6.0% to 6.1% levels in June, and will be between 5.4% and 5.6% for next year. Since the Fed has underestimated the strength of the job market in the past, we would not be surprised if the Fed revises its estimates down yet again in the coming months. Even though wage growth has been modest thus far, an improving economy and structural elements may eventually push wages and inflation up.
Fed Chair Janet Yellen has often argued that underutilization of labor resources still remains significant, and therefore the Fed’s continuing easy money policies are justified. One of the indicators the Fed watches is the labor force participation rate, which indicates the share of population working or looking for work. The measure was 63% in August, down from 66% in December 2007. Although it is near its lows, we don’t think the number will be affected by people reentering the workforce due to the improving economy. We believe a significant part of the decline in labor participation is structural and not cyclical. For example, U.S. factories that used to employ thousands now employ far fewer, and those they do hire require a different skill set. The majority of laid-off workers cannot find jobs without re-training, or they risk leaving the labor force permanently. In addition, the U.S. faces an aging population that will eventually begin retiring. As a result of these two factors, we believe that the job market is closer to the point at which employers will need to increase wages to hire and keep workers.
The U.S. and U.K. have had more vigorous job-rich expansions than the euro-zone. Their inflation rates are also closer to the 2% that major banks consider optimal for their economies. Mark Carney, the Governor of the Bank of England, recently announced that interest rates could start to climb in early 2015 from their record low of 0.5%. He said that “with inflation at 1.6%, continuing downward pressure from the appreciation of [the Pound] Sterling, and with slack remaining, the current inflation environment is benign. But it will not remain benign if we do not increase interest rates prudently as the expansion progresses.” We applaud Mr. Carney’s exhortation to stay ahead of the curve on interest rates. Perhaps Ms. Yellen should take notice.
Based on the minutes from the July Federal Open Market Committee meeting, it seems that some participants are increasingly uncomfortable with the committee’s forward guidance on keeping its benchmark rate low for a considerable time. Some expressed that the Fed should consider raising borrowing costs sooner than anticipated due to improving labor markets. Even though the September minutes seemed to indicate more caution, 14 of 17 officials said that they continue to believe the Fed’s first increase of short-term rates will occur in 2015. This compares to 12 of 17 in the June minutes, however, Ms. Yellen seems to be comfortable waiting years before increasing rates since she tends to believe that the low unemployment rate overstates the improvement in overall labor market conditions. For now, these groups remain at odds. If you believe Ms. Yellen’s opinion is the only one that really matters, then expect the first rate hike to be later rather than earlier. This would certainly be in line with a long standing Fed tradition of keeping “easy money” policies around too long.
Hopefully history doesn’t repeat itself as it did in the last round of rate hikes. The fed funds rate was lowered from 6.5% in December 2000 to 1.0% by June 2003. It was kept at 1.0% until June 2004 when the rate was finally raised by 0.25%. Housing starts took a sharp spike up in 2002 and then continued to climb through 2005. We believe that by holding the benchmark rate low while the economy rebounded and bubble conditions in housing fomented, the Fed might have been partially responsible for the resultant banking crisis of 2007-2008. We do hope that the Fed will learn from this and not fall behind the curve on interest rates this time around.
This brings us to potential bubbles in the market. It is interesting to note that in her semi-annual monetary policy testimony to Congress, Ms. Yellen called out the valuations of leveraged loans and high yield bonds as potentially excessive. She also pointed to the valuations of social media and biotechnology stocks as being substantially stretched. The leveraged loan and high yield bond market, combined, actually account for a relatively small portion of the fixed income market as a whole and similarly, the market capitalization of biotech and social media stocks is only a small percentage of the total equity market. If any market should have been singled out, we believe U.S. government and mortgage securities, which constitute a much bigger slice of the total fixed income market, are starting to exhibit bubble tendencies with little value for investors looking to achieve real long-term returns. We are also concerned that there are price distortions in U.S. government bonds given that most are now in the hands of lenders-of-last-resort (i.e. the Fed, Japan and China), who are not driven by the normal investors’ profit motive.
In sum, we still believe that current Treasury yields do not adequately compensate us in a continuing benign interest rate environment, nor provide enough protection in case we enter a rising interest rate environment. Post Labor Day, the high yield market experienced a flood of new issues. As a result, many fund managers had to sell bonds in order to raise cash to buy new issues. This coincided with large investor outflows from high yield funds, especially high yield exchange traded funds (ETFs). When this happens, we usually see a large amount of short term paper hitting the market at very attractive yields. This time has been no different. As you know, we generally keep a healthy cash position, patiently waiting for these good investment opportunities to materialize. It is what we look forward to. Cash can allow us to take advantage of this recent sell-off, buying attractive bonds at higher yields while aiming to maintain our relatively short duration. Longer term, we look forward to the time when longer-dated high yield bonds and investment grade bonds may present attractive investments too.
As always, we thank you for the trust you place in us and welcome any questions or comments.
Sincerely,
Carl Kaufman Simon Lee Bradley Kane
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.
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Consumer Confidence Index (CCI) is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
Personal Consumption Expenditures Index (CPE) is a measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households; the measure includes data pertaining to durables, non-durables and services. It is essentially a measure of goods and services targeted toward individuals and consumed by individuals.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
Exchange traded fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.
Duration measures 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.
One cannot invest directly in an index. [11160]
© Osterweis Capital Management
© Osterweis Capital Management
