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Bond Market Commentary and Analysis

Bond Market Commentary

Bond Market Commentary

They said it… So it must be true?
By Doug Drabik
September 26, 2016

The top circulated financial newspaper in the country (The Wall Street Journal) posted a news story talking about “Bond Basics”. It said, “A bond’s yield shows how much income it will generate annually. This yield, derived by dividing the contractual interest payment by the current price, falls as the price rises.”

The implication, or the way I viewed it, makes it sound like an investor should be cautious owning a bond because its income is sure to fall when prices go up. If this is any reader’s interpretation, there is yet another erroneous message being delivered. As a matter of fact, I will argue that this couldn’t be much farther from the truth.

First of all, interest divided by current price is the current yield. That’s it. It is a point-in-time calculation. The current price of a bond has nothing at all to do with the yield or income that an investor is achieving on their holdings. One of the most powerful reasons an investor holds bonds within their portfolio is for its protective qualities: 1) predictable cash flow, 2) defined income, and 3) known time period when face value (barring default) will be returned. These 3 qualities do not change when a bond is held to maturity regardless of any changes in interest rates! When interest rates change, prices change but an investor’s bond portfolio cash flow, income and maturity DO NOT CHANGE! What is changing is the moment’s opportunity or the current entry point into the market.

Articles from well-read/accepted periodicals and well-known financial figure-heads seem to carry considerable weight with casual and sophisticated investors alike. We all are influenced by what we read making it more important to decipher wording. The slant and relevancy of the information is often “awkward” or can easily be taken out of context. Famous wealthy financial figure-heads typically possess dissimilar portfolio goals and needs and often manage money from a total return perspective. The message and applicable audience can easily be blurred. Just because it’s in print or uttered from famous lips, doesn’t make it true and/or appropriate for all investor types. Understanding the basics is essential. Knowing what you own and why you own it, even more so.

The market gets a “time-out”?
By Doug Drabik
September 12, 2016

It is natural to view situations and develop opinions through our own eyes sometimes concealing the details and realities of the big picture, but has the investment world become too bored, too programmed or perhaps too sensitive? Was last week a precursor to things to come or simple a market “time-out?”

On Friday, the Dow Jones Industrial market fell 360 points, the S&P 500 dropped 55 points, gold fell $10.27, oil dove $1.74 and the 10- and 30-year Treasury rates were up 8 and 10 basis points respectively, reflecting price drops on both. It is not often that all these markets move in accord. The catalyst for all of this appeared to be that two of the currently QE (quantitative easing) active central banks (Bank of Japan and European Central Bank) pronounced that their QE operations are under review and that there may be no need for extra stimulus.

The markets perform as if they are addicted to every word expressed by the central banks. Market direction and volatility seem affixed to each statement. The problem is the inconsistency of message delivered from the various central banks and our own Fed members. The Fed proclaimed themselves data-dependent from the start of the QE program but seem to soften on that assertion when they simply want to assert their ability to raise rates at their discretion.

Here’s what we know: GDP was lackluster in the 1st half of the year. The manufacturing index took a sharp decline, auto sales have slowed, the business index is down, forward-looking new orders are down, non-manufacturing export orders are down, jobs are mediocre and inflation hovers well below the initial 2% target trigger level. In addition, the U.S., the biggest and most liquid economy, continues to maintain the highest interest rates of all the major global economies. Fed action to push short-term rates could flatten the yield curve further, potentially impeding financial entities such as banks, with the ability to produce adequate margins or to be incentivized to generate loans.

Despite all the contradictions, the Fed is still signaling for a potential move sooner than later and the pause expressed by the European Central Bank and Bank of Japan may help their argument. The markets react instantly when it appears plausible that the central banks are about to turn off the stimulus they have been operating with. As I have commented many times on this medium, these markets have been very central bank driven. This may prove to be a very tricky moment as we await to see whether this is a “time-out” or a real direction change.

Certainly uncertain
By Benjamin Streed, CFA
September 6, 2016

Here in the US we find ourselves faced with an odd scenario of being the proverbial “best house on the block” as we are chugging along a decent clip, creating jobs and have a healthy consumer to keep things moving in the right direction. To borrow a word from Alan Greenspan, here’s the big conundrum: do we raise rates later this year (September, November or December) or do we remain “data dependent” and allow ample time for the Fed’s chosen metrics to comply with their own stated goals/thresholds? With the assumption that the data would beat expectations, Friday’s jobs report was supposed to be the “all clear” signal for the Fed to go ahead and raise rates for the second time. Whoops. The data missed at +151k, expected +180k while average hourly earnings growth remains muted, stifling any hopes that inflation is just around the corner. Bloomberg futures data show that Friday’s jobs report did little to move the odds for a September hike as it remains in the ~30% range and December sits at ~60%. Looking at the chart below, it appears as if the markets are a bit exhausted over “Fed speak” and don’t appear convinced another hike is imminent.

Whether the Fed “doves” or “hawks” win the next battle, the committee finds itself in the unenviable position of having convinced us that another hike is around the corner while ongoing economic data continue to paint a less rosy picture. The US economy is in no way performing poorly, but instead is continuing to show slower growth than many had hoped or planned for. This isn’t necessarily a bad scenario; it’s just not as robust or as broad as many had anticipated going on eight years since the Great Recession first hit. This is especially true when considering the state of much of the developed world that continues to battle with aging demographics, low or negative interest rates amidst some combination of disinflationary (slowing inflation) price pressures, weak jobs growth, or even deflation (falling prices) which can pose a very real challenge for monetary policy.  

What’s it going to take to see higher rates here in the US? Further positive economic data? Signs of imminent inflation or rampant wage growth? Or will any move by the Fed simply be an act of desperation as it simply feels the need to do something, anything, to continue towards normalization? Hard to tell, but the markets think that although September is possible it remains unlikely. Even so, as the Fed is no longer engaged in active/expanding monetary easing it can influence the short end of the yield curve, but longer-term rates will be directed by the global financial markets. As we’ve written many times before, yields in the US continue to offer value relative to the rest of the world, with corporate bonds looking very attractive compared to their peers overseas (many of which are subject to central bank purchase programs). 2016 marks a new global record for monetary stimulus, with ~$160 billion in bonds being purchased by central banks every month and is expected to increase next year to ~$180 billion.

How does this affect the US? According to Bloomberg index data, global investors seeking high quality sovereign debt that yields > 2% will have only a few places to look: the United States, or one of the following: Greece, Portugal, Australia, Singapore, Italy, Spain or New Zealand. Of this universe, the US represents 83% of the available securities on the planet. Staying with the same yield bogey, for those willing/able to invest in corporate debt with at least and ‘A’ rating, the US represents ~80% of all available securities. Federal Reserve data show that $400 billion of US corporate debt is being purchased by overseas buyers, helping keep a lid on yields here at home. Given what’s going on overseas and the truly global nature of the bond market one question remains: when it comes to longer-term US yields, does it even matter if/when the Fed hikes?

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.