The bond market has settled in. The week provided minuscule changes to interest rates, yet the tone of things to come has done anything but settle in. So many questions, so many opinions and so many different answers. Perhaps the market is stalling, attempting to figure out what the future fiscal policies will mean. Perhaps the markets have settled down because of the continuation of modest growth, unhurried inflation and satisfactory employment levels. Since experts and investors alike seem to bungle predictions with scary consistency, maybe it’s time to just think about some of the factors that could affect interest rates going forward.
The Fixed Income Quarterly is set to be released this week. It will focus on “What Ifs” instead of making pointless predictions of the future. Over the last 9 years or so, we have been in a highly regulated, global central bank controlled environment. The new administration is promising significant deviations from these policies. The new programs, the ability to pass changes, the time frame to implement transformations, the acceptance/delivery and the global reactions are all unknowns. This isn’t a time to panic or predict but a time to pay close attention to what transforms and stay diligent to appropriate asset class allocation in protecting one’s wealth.
Equity markets may continue to surge. Changing tax rules may instantly and favorably change price/earnings ratios without companies even making any adjustments. If equity portfolios continue to rise in value, it will be important to continue to maintain an appropriate asset class blend. If making money is half the battle, maintaining it is the desired culmination.
Interest rate disparity among global economic powers appears unremitting. Will this remain a headwind to higher domestic interest rates? Inflation has inched up but still shy of the desired Fed level. There are all sorts of dividing rationales as to whether it will take off or continue in what has been a fairly tight range for 30 years (see the upcoming FIQ for greater detail).
The central banks around the globe have ballooned their balance sheets, increasing money supply. At the same time, member bank excess reserves have increased, averting drastic change to actual money circulation. Will the central banks unwind the balance sheets and/or member banks begin to loan out excess reserves to businesses and individuals? Any of these events can potentially impact interest rates.
The point is that this hardly seems like a time to make predictions. Instead, it is time to observe actual changes as they unfold and react with conscientious detail to protecting your wealth via appropriate asset allocation.
The market continues to show both a mix of optimism, thanks in large part to a strong earnings season and hope for pro-growth initiatives from the Trump administration, while also displaying heightened uncertainty regarding fiscal policy and the future of key metrics like inflation and wage growth. “Markets are set up for a one-direction trade” as Greg Peters from PGIM, a $600 billion fixed income manager, stated in a recent report. Furthermore, “What’s really interesting about this time is that it is so uncertain. But optimism is equally high. Those two things rarely ever happen together”. Well said, and sums up the current zeitgeist perfectly. For equities, look at the VIX index (blue line below), a measure of equity market volatility, as it now rests at only 10.85, the lowest level since 2014 and appears to be without a pulse. The VIX is dead, long live the VIX. Meanwhile, the BofA ML MOVE Index, a measure of bond market volatility has clearly diverged from their usual “hand in hand” trend since the November election. What this means going forward is unclear, but such a divergence is reflective of the broad equity euphoria and the unease surrounding portions of the Treasury market.
Bond markets remain focused on the continued tepid inflation data that continues to remind us that the Fed will have a difficult time raising rates three times this year as it intends to do. In fact, according to Bloomberg data the probability of a hike in March is only 28% and we don’t see a >50% probability for a hike until July. Obviously, much of the market’s perception of a rate hike will hinge on what (if anything) comes from the Trump administration and whether the proposals for both personal and corporate income tax rates meet the heightened expectations that have already been priced into much of the financial markets. In the next two to three weeks we’ve been promised a “phenomenal” tax plan, but details are nonexistent at this juncture and we’ll have to remain patient before we can understand the true implications of the plan or when/if it will be implemented. On this train of thought, BlackRock’s CEO, Laurence Fink, recently made remarks on Bloomberg television that took the fixed income world by surprise. He noted that we’re living in a “bipolar world”, one where the 10yr Treasury yield could spike to 4% or 2%, and both are equally as likely in his eyes. “There’s a greater probability that the 10yr Treasury is below 2%, and we’ll have a market setback of a considerable amount”. Why? He doesn’t believe that all of the assumed/expected fiscal stimulus measures and tax cuts will be approved/implemented, and even if they are, could take until 2018 to be put in place. Interesting thoughts from the head of a $5.1 trillion money management firm and worth contemplating over the next few weeks. Data provided by the Peterson Institute for International Economics via Bloomberg show that no US trade deal has ever taken less than 18 months from launch date to signing, with implementation taking anywhere from 20 to 100 months to be fully implemented. Seems like there’s a lot of work still to be done.
Interest rates inched up last week 8bp to 10bp 5 years and out on the yield curve. For the month, all points on the yield curve are within 5bp from year end 2016. The 10-year Treasury has seen the largest difference moving a mere 4.6bp from 2.444% to 2.49%. Interest rates, since year end’s election volatility, appear to have settled into a tighter trading range.
As tabloid-like reporting overshadows objective news, the more challenging task may be separating facts from dramatization. It doesn’t hurt to remind ourselves where we actually stand: a financial market with slow but steady growth, inflation at healthy levels, adequate employment and a favorable global position. It seems that in the future, when the current times are looked back upon, it will be recorded that these were very stable times for the American economy; however, living in the present, the news seems to paint a more turbulent picture.
President Trump’s first 10 days in office suggest that white house intends to be active. Politics ordinarily are not the center of financial commentary, but there is no denying that things may not be run as in the past. Academia and political personnel are being replaced with business people and it appears the United States may be run with more CEO-type leadership. Like it or not, it doesn’t matter. The votes have been cast and changes may be very impactful to our bond markets. Regulation (or de-regulation), tax code change and trade agreements are among the probable impactful future transformations.
Monetary policy, as set by the central bank (the Fed) has carried the burden of creating market order. It is now expected that the Fed will have help with fiscal policy playing a bigger if not more dominant role. How this will play out is very much in waiting. The initial enthusiastic market reaction felt after the election has settled down to reality. Keep in mind that bond direction is not an overnight occurrence. Generally, it takes months and perhaps years to form. Much like fixed income strategy for wealth-protecting purposes, it should typically be regarded in years if not decades of desired results. Expect that policy changes of any kind may take that long to filter into tangible results. Tax code changes could have a more immediate impact on our markets via corporate profitability and personal disposable income. For now, keep one eye on the market and the other on shifting policy. Change is coming but the timing and effectiveness are yet to be revealed.
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.