Bond market update: What's up with Treasuries?
Q: Despite the biggest jump in nonfarm payrolls in two years on Friday, longer-term bonds rallied and yields fell. Why? Everybody has been trying to figure out Friday’s rate action. After initially jumping 5 to 7 basis points on news of the stronger-than-expected jobs report, the 10-year Treasury reversed course, eliminated the losses and closed positive (in price) on the day.
While there were some weaker elements in the nonfarm payrolls report—wages were flat and labor force participation declined—the sheer magnitude of the new jobs (288K for April, and 36K in upward revisions to the prior two months, raising the monthly average gains to 238K over the last three months) on top of the big drop in the unemployment rate (from 6.7% to 6.3%) should have caused a tough day for bonds. However, geopolitical concerns (Russia/Ukraine), central-bank buying in China and overall disappointment from the bears on the lack of market follow-through were the most likely reasons behind the bond market reversal. (On that latter point, using price action to justify price action admittedly is a somewhat circular argument!)
Q: Federated has been in line with the consensus on Wall Street for longer rates to rise this year as the Fed tapers and the economy strengthens, yet year-to-date, yields have traded at generally lower levels than where they were at the start of the year. What will it take to break out of this range? Clear signs of inflation, and corresponding declines in the unemployment rate coupled with increases in labor market participation.
Q: How should fixed-income investors be positioned in this environment of relatively strong Treasury prices and relatively narrow spreads on credit products, i.e., high-yield, investment-grade and emerging-market bonds? While being short Treasury duration may not provide immediate satisfaction like it did when we initialized our position a year ago at this time—inflation, after all, is a lagging indicator—it still seems the prudent position based on economic fundamentals and valuation.
Regarding the non-Treasury sectors, spreads—the gap between Treasury and comparable maturity credit bonds—aren’t necessarily overly attractive at these levels but are still reasonable. When combined with decent underlying macro fundamentals such as solid corporate balance sheets, robust earnings, and continued and likely accelerating economic growth, corporate bonds—both investment-grade and high-yield—should continue to outperform Treasuries. The environment may be even better for emerging-market bonds, which suffered significant sell-offs last summer and again earlier this year and thus are well positioned to benefit from the aforementioned fundamentals, aided by the potential for more sizable spread tightening.