Market Memo: Free to choose?

09-29-2017

I’m probably butchering his words, but in describing the Mississippi, Mark Twain observed that it rarely was the same river twice, as floods and storms and the seasons worked to constantly change its channels and flow. In many ways, this describes today’s bond market. The reality is that, given the Federal Reserve’s unprecedented intervention in the Treasury and mortgage-backed securities markets (see chart at bottom), the bond market really hasn’t been a normal, natural free-flowing market for eight years and is unlikely to become one for years to come as the Fed gradually unwinds its balance sheet.

Why should fixed-income investors care? Because investment decisions based on market fundamentals in prior cycles may not work all that well when the market is operating under a command/control model run by the central banks. One would be hard-pressed historically to find 10-year Treasury yields under 3% in an economy entering its ninth year of expansion, unemployment below 5% and the equity market at historical highs. Yet that’s what we have, and from our vantage point here at Federated, 3% on the 10-year is unlikely this year. And the peak in yields for this cycle is going to be decidedly lower than the 5.25% we saw in the cycle that preceded the Great Financial Recession.

A global guessing game
True, stubbornly low inflation is playing a role in stubbornly low rates. But even as core prices are failing to hit and hold at 2%, that still doesn’t explain why the 10-year is trading at around 2.3%, only 100 basis points or so above the Fed’s target rate for overnight bank borrowings. It’s not just the massive Fed purchases of Treasury and agency securities in the post-crisis era that have distorted the marketplace. Similar interventions of the command/control kind have impacted government bonds in Europe and Japan. German and Japanese yields are negative out to seven years. Rates may be moving higher but normalization will take some time. 

Markets are caught in the guessing game over inflation, growth, future central bank policy and the probability of the passage of fiscal programs, all of which make this the most policy-inflected market in my 20+ years of looking at global rates. Just this week, Fed Chair Janet Yellen gave a presentation in Cleveland, “Inflation, Uncertainty, and Monetary Policy,” where she asked rhetorically how the Fed should deal with the current uncertainty. “How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments. … But we should also be wary of moving too gradually.”

Credit and floating-rate strategies favored
So what should investors do? By all means, don’t avoid bonds. Bonds can still fulfill their mission in your asset allocation despite low nominal yields: generating a known income stream, reducing your total portfolio’s volatility and hedging against deflationary events. Absent the inflationary shock everyone has been waiting for in the past 10 years, Treasury yields are likely to find significant support around the Fed’s projections for the terminal rate for the cycle, which is now 2.75%. Remember, though, that rates can always surprise to the downside as they’ve done since the crisis started in 2008. Go with what you know. What’s my current distribution yield given my cash-flow needs? What’s my duration and my downside if rates do jump aggressively?

Federated’s fixed-income team continues to recommend durations of no more than 6 years, with an overweight to credit products such as investment-grade and high-yield corporate bonds. We think you should use floating-rate products as a complement to rather than a substitute for a fixed-rate product. We’re also looking for the yield curve to continue to flatten as the Fed continues toward normalization, and expect the dollar to regain some of what it has given up since the start of the year as tax reform makes its way through Washington. You do have some choices after all.


Assets as of 9/27/2017 FRED = Federal Reserve Economic Database Shaded area represents 2007-09 recession