In the aftermath of the US presidential election there was a general feeling of euphoria, that “risk on” would dominate the investment landscape and that economic growth, inflation and job creation would abound as taxes were cut and the regulatory backdrop trimmed down. This, like many other assumptions, was based on hope and led to soft economic data (surveys and sentiment) diverging strongly from hard (measurable) data to the largest margin on record. Nearly four months into the year and the euphoria has all but worn off, leaving the markets to once again wrestle with the reality of our current situation. One of the most erroneous and misleading assumptions from the election was that there was a supposed abundance of “cash on the sidelines” just waiting to get into equities once the “all clear” was signaled. Furthermore, the multi-decade rally in the bond market was supposed to come to a close as well and funds in this sector were supposed to flow into equities as the aforementioned growth scenario panned out. “If you can find something everyone agrees on, it’s wrong” states the timeless quote from Mo Udall, a former US Representative and professional basketball player. This “Great Rotation” away from bonds and into equities is emphatically, in the lingo of our times, “fake news”. According to the Investment Company Institute (ICI) which measures net fund flows for both ETFs and mutual funds paints a pristine picture, one that proves that there is not only an ongoing demand for high-quality, income-producing assets but a trend that has seen a ramp up in demand in the post-election world. The longer-term trend is below (first chart), and over the last three year’s we see a clear demand for fixed income securities despite the presumption for higher rates, inflation and growth in the US.
What happens when we look more near-term? Do the data show a change in sentiment? The short answer is no, but you likely already inferred that having read this far. There was some volatility as investors struggled to initially wrap their heads around the election results, but the reversal in trend reversed within a few weeks and markets quickly rebounded back to their longer-term trend (with the exception of muni flows, although these are recovering, albeit more slowly). Interestingly, despite the initial outflows from municipal bonds the aggregate demand for fixed income remains solidly in first place thanks to the unwavering demand for taxable bonds. The muni market is recovering as the Trump tax code changes are delayed and continue to be called into question. Overall, the takeaway is to always look at the data and question any rhetoric that presumes a massive shift in sentiment, no matter how good it sounds. Larger macroeconomic forces continue to be at play, forces that have an ongoing (and increasing) demand for high-quality, income-producing assets like bonds. At the end of the day, there is a global savings glut and demand for bonds outstrips supply by many, many times.
The past week brought with it the first concrete signal that the Federal Open Market Committee (FOMC), more commonly known as “the Fed”, would likely begin to taper the size of its massive ~$4.5 trillion balance sheet sometime in the future. The details of the Fed’s March meeting, in which they hiked rates by 25 basis points with only one dissenting vote, included a basic roadmap for how this will likely materialize. A reduction of both Treasury and mortgage securities was always understood to be an inevitability, but the real question revolved around when it would begin (likely later this year), how quickly it would commence and how the central bank would communicate with the markets as it heads into uncharted waters yet again. At this juncture, the summary appears to be the following: they will allow bonds to “roll off” and it will be done gradually over a long period of time. Federal Reserve Bank of San Francisco President John Williams said it may take five years to shrink the balance sheet to a more normal size (not entirely eliminate it). Williams also said officials would likely move slower on future rate increases and the reduction of the balance sheet if both measures are utilized together. Interestingly enough, some Fed officials have even made remarks that the normalization/reduction of their holdings could be implemented instead of another hike in the federal funds rate, thereby replacing their primary monetary policy tool with an entirely new one. As a result of this announcement, bonds rallied on Wednesday signaling that markets were anticipating some sort of communication on this topic and the idea of a “taper instead of a hike” change in language was initially seen as somewhat dovish.
The chart above details the state of the Fed’s balance sheet as of the end of March, and worth a reminder that a significant portion of their overall holdings are short-term Treasuries due in less than five years. For example, should the Fed undertake a “roll off” approach, by 2022 a cumulative $1.5 trillion of securities would vanish representing roughly one third of the total. Despite this additional color on the Fed’s plan, market expectations for the yield on the 10-year Treasury haven’t moved meaningfully. The chart below details the median expected yield (orange) of 55 economists surveyed by Bloomberg. Interestingly, the yield curve flattened on the announcement and bonds saw further strength after the weak payrolls report on Friday morning.
So where does this leave the markets? On one hand, we saw the 10-year Treasury yield fall below 2.30% for the first time in 2017 due to the Syrian airstrike which pushed us to 2.29%. The payrolls report saw further declines in yields to roughly 2.27%, yet both times markets resisted a move much lower, potentially establishing a resistance level in the 2.30% area. Markets are pricing in a strong possibility of yet another Fed rate hike in June (yet very little chance in May). June odds now sit at 66% according to Bloomberg data, and we could find ourselves in the 2.30-2.40% trading range unless something comes along to upset the applecart. Market expectations for increasing yields have been something of a “broken record” in the post-recession world and 2017 is once again showing that there is a very real struggle between expectations and reality.
At the beginning of every year, there is a sense of optimism compelling many investors and seemingly most experts to predict a better, more robust and prosperous financial future. At least that’s the way it’s gone the past several years. Now, the first quarter of 2017 is in the books. The new administration’s honeymoon is over. The market, which tends to trade on anticipation or the rumor, seems motionless awaiting the next directional indicator. It’s beginning to look a lot like… well, last year.
|Treasury Yields||12/30/16||04/03/17||Net Chg|
Source: Bloomberg LP, Raymond James
The Fed hike in mid-March has worked to keep short-term rates slightly higher than the close of 2016 but it’s proving to have little influence on the mid part or longer-end of the curve. The market seemed to get ahead of itself propelled in large part by the enthusiasm of a new and promising change to the political front. What is beginning to sink in is that changes cannot occur overnight. Even in a best case scenario, it may take more than months or even years for implementation of new policies to take effect; however, don’t mark the scorecard just yet. Anticipation may have pushed too quickly but there’s a lot of time for much to unfold.
The economy may be in better standing than given credit. As a matter of fact, when future text refers back to the present, it may reveal an economic time period that is well-regarded. Although modest, the economy has provided one of the longest post-recession growth periods, near full-employment and restrained inflation. There is not a lot “wrong” with the economy but it has been met with numerous headwinds such as global rate disparity created by the struggling economies of most other economic powers worldwide.
It is difficult to be patient but doing so may be rewarding. We are a nation and generation of instant gratification stuck in a market that works on its own merits. The Fed and monetary policy are still driving while fiscal policy gradually and deliberately unfolds. The bond market has never been a sprint event but is more like a long-distance marathon. Nothing has really changed from the early year anticipations except perhaps the realization that it is not an overnight event.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
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.