Rotations, Reversals, Rising Rates: A Time to Reposition
The Federal Reserve’s intent to raise rates, coupled with the election of Donald Trump, may have ignited a Great Rotation from bonds to equities, calling into question the relative safety of bonds that investors have experienced over the past three decades. This month, we examine the selloff in bonds and the stock market’s surge, and discuss the need to reposition portfolios to benefit from the Great Reversal.
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For several years, investors have anticipated a “great rotation” from bonds into equities, and for several years, they were dead wrong. In fact, even as equities were quietly rising for the past years, both domestic and international money has continued to surge into bonds. At long last, that is beginning to reverse, which demands a reconsideration of strategies that seemingly have worked so well and so easily for so long. As long as bond prices were rising, pouring money into assets that had a certain return looked like a slam dunk. No longer.
The primary reason for the decades-long bond bull market is simple: Since 1982, bond prices have risen as interest rates have fallen. There have been several periods of bond volatility, most recently with the “taper tantrum”, as markets adjusted to the end of the Federal Reserve’s (Fed) policy of quantitative easing. But for the most part, bonds have been on a three-decade-plus bull run. Meanwhile, more volatile and unpredictable equities have gone through intense periods of double-digit gains and losses. Add to that a general climate of skittishness that has bested financial markets and financial players since the 2008-2009 crisis. When traders and markets panic, their panic is usually first manifested in equities, given their liquidity. Although arcane corners of the credit markets are also susceptible to panic and sharp flux, they usually are less evident, and ebb and flow without triggering reactions elsewhere in the financial ecosystem.
Two things, however, changed sharply in the past months: the evidence that the Fed is ready to bring short-term interest rates back up (modestly) and the election of Donald Trump.
The Fed now has the evidence to support what it has wanted to do for some time. Headline unemployment is below 5%; there is modest (though uneven) wage growth; and inflation is pushing 2%. It hardly represents an overheated economy, but it is sufficient to bring the most extreme easing to an end.
Make no mistake: This is not your grandfather’s tightening. Increasing short-term rates from 25 basis points to 1% would still leave those rates far lower than at most points in the 20th century, and an expectation that normalization is ahead that will bring rates back to that point is almost certain to be wrong. But in relative terms, this is still a degree of tightening, and global bond markets have begun to take notice.