With a Whimper Instead of a Bang: Is the Great Bond Bull Market Over?

Charles Schwab: With a Whimper Instead of a Bang: Is the Great Bond Bull Market Over?

By

Kathy A. Jones

- July 20, 2016

Key Points

• Bond yields in major countries have rebounded after plummeting to all-time lows in recent weeks, leading some to conclude that the bond bull market is over.
• However, the end of the bull market doesn't mean a bear market is starting, as slow global growth, deflationary pressures abroad, a firm dollar and demographic trends are likely to keep yields low.
• Investors should focus less on short-term changes in the market and more on structuring a fixed income portfolio that can work for them over the long run.

The bull market in U.S. Treasuries looks set to mark its 35^th anniversary this fall—assuming it continues. It has been a good run, with investors enjoying attractive returns from their bond portfolios over the years. Ten-year U.S. Treasury yields peaked at 15.84% on September 30, 1981 and fell to a modern-era low of 1.36% on July 8, 2016. (Remember, falling yields reflect rising prices.)

But yields have since bounced back, rising to 1.59% in mid-July. Is this a sign the bull market has run its course? Pundits have repeatedly declared the end of the bond bull market over the years, but, to paraphrase Mark Twain, news of its death has always been premature.

Ten-year Treasury yields, 1970-present

Source: Bloomberg. 10-Year Treasury Constant Maturity Rate (USGG10YR). Data as of 7/15/ 2016. Past performance is no guarantee of future results.

We're not willing to declare the bond bull market over, but we will concede that the recent drop in Treasury yields looked overdone in light of the solid U.S. economic data reported over the past few months. Looking at the U.S. economy in isolation, one would expect investors to be more sanguine. Economic growth is running at a steady 2.0% to 2.5% pace, and inflation is edging higher. Excluding volatile food and energy components, inflation is already above the Federal Reserve's 2% target by some measures. The unemployment rate—at less than 5%—is near where most economists believe the "full 'employment" threshold lies and wages are edging higher for most workers.

Normally, yields fall when the outlook for the economy is uncertain. There is little in the data cited above to support the recent drop.

Moreover, the market probably went too far in reducing expectations for the pace of rate hikes by the Fed. In the immediate aftermath of Britain's vote in June to leave the European Union—better known as the Brexit vote—market expectations for an increase in the federal funds rate this year fell to just 15%. They have since rebounded above a 40% likelihood of a rate hike, which seems more realistic to us.

Implied probability of a Fed rate hike

Source: Bloomberg, World Interest Rate Probability. Data as of 7/15/2016.

Why bond yields will likely stay low

However, bond yields are determined in the global market, and forces outside the U.S. are likely to keep U.S. bond yields low, in our view. The market may have overreacted to the actual Brexit vote, but the specter of rising nationalism and a potential increase in trade barriers suggested by the vote also exacerbated long-standing concerns about global growth. Global trade volumes have fallen to half their long-term historical level in recent years. Since trade is highly correlated with global growth, any indications that the free movement of goods, labor or capital across borders might slow tend to stoke concerns about the global economy.

Gross Domestic Product (GDP) versus Trade Volume – World

Source: International Monetary Fund, World Economic Outlook Database, world gross domestic product and world trade volume of goods and services, annual data as of 12/31/ 2015. Shaded areas indicate recessions.

Consequently, central banks around the globe have been easing monetary policies by pushing short-term interest rates to historically low or even negative levels and expanding bond buying programs. The Bank of England has already indicated it is likely to cut rates in August due to the negative impact that the "Brexit" vote is expected to have on its economy. The European Central Bank has pushed short-term interest rates into negative territory and expanded its bond-buying program to include corporate bonds.

The Bank of Japan is even said to be moving toward dropping "helicopter money" to stimulate its economy. (Helicopter money refers to a concept originating with economist Milton Friedman, whereby the central bank provides money directly to citizens—as if dropping it from a helicopter—in order to increase spending and prevent deflation. In practice it is likely to take the form of the government issuing perpetual debt.) With major central banks already holding large portions of outstanding government bonds on their balance sheets, the potential for higher bond yields appears limited, in our view.

Central banks' holdings of government bonds as share of outstanding debt

Source: Federal Reserve Board (U.S. Fed), European Central Bank (ECB) and Bank of Japan (BOJ) data as of 3/31/ 2016. *Holdings including government debt of Germany and other eurozone countries as of 3/31/2016.

Meanwhile, demand for yield remains strong, especially in countries with aging populations. Pension funds, insurance companies and retirees are all seeking some sort of positive yield to help generate income. With more than $10 trillion bonds priced with negative yields to maturity, investors have driven up the prices of all types of bonds—even the riskiest, such as high-yield corporate and emerging market bonds. As paltry as they are, U.S. bond yields are significantly higher than yields in most other major countries, leading foreign investors desperate for positive yields to the U.S. bond market.

U.S. yields are by far more attractive than yields in other major countries

Source: Bloomberg. Data as of 7/18/2016.

The inflow of foreign capital into the U.S. has boosted the dollar by more than 3% on a trade-weighted basis since the Brexit vote. The biggest increase has been against the British pound, which fell 11% against the dollar, but the euro is down about 3% and even the Chinese yuan is 2% lower. A strengthening dollar tends to hold down growth by making U.S. exports less competitive and reduces inflation because it causes import prices to fall. The trend in the dollar is a key indicator we watch since it often has the same impact as a Fed rate hike—slowing growth and lowering inflation.

The dollar is trying to do the Fed's job for it

Source: Bloomberg, daily data as of 7/18/2016. The U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. Past performance is no guarantee of future results.

What to do now:

 

We've always believed that the bond bull market would end with a whimper instead of a bang. Yields may have hit generational lows, but it's unlikely they will rise sharply or substantially any time soon. The forces holding yields down—slow growth, deflationary pressure from abroad, a firm dollar and demographic trends—are likely to remain intact for the foreseeable future.

We are concerned that in response to these factors, yield-starved investors are stretching too far into low-quality bonds and/or long maturity bonds without getting compensated for the risks. When evaluating a fixed income portfolio here are a few considerations to take into account and some resources to help:

Start with realistic expectations. We don't expect rates to rise soon, but we also don't expect returns for fixed income investors to be as strong in the next year as they have been in the past year. This article explains why market returns may not be as good in the future.

Match your bond holdings to your investment needs. Treasuries and investment grade bonds tend to add stability to a portfolio, while bonds with more credit risk can add income but carry a higher risk of loss. This article explains how to include an appropriate allocation to each, based on what you want to achieve.

Consider a laddered bond portfolio. Bond ladders—an investment strategy in which you purchase individual bonds with staggered maturities, spreading investments across a particular time horizon—are a way to avoid trying to time interest rate changes. The goal of a ladder is to have bonds maturing at set, but staggered, intervals. Short-term bonds provide stability and create opportunities to reinvest if rates rise, while the longer-term "rungs" of the ladder generate income. This article provides more details on how they work.

See the opportunity. Higher interest rates could spell the end of the bull market, as prices tend to fall when rates rise. But higher interest rates would also be a welcome change for investors seeking income in a low-yield world: Rising interest income would be a boon for investors with a longer time horizon. Consult a Schwab representative to get an evaluation of your current bond holdings and help with constructing a portfolio that meets your needs.

Financial Review

Heating Up

Sinclair Noe — June 16, 2016

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

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DOW + 92 = 17,733
SPX + 6 = 2077
NAS + 9 = 4844
10 Y – .04 = 1.56%
OIL – 1.84 = 46.17
GOLD – 11.30 = 1281.20

Well, this was a strange day. The major market indices started the session lower and looked ready to slide into a sixth consecutive loss, but after about an hour of trade, prices started moving higher. Even with the weakness we have seen over the last week or so, the S&P 500 is still only a little more than 2% off its 2016 closing high for the year. From that perspective, can you recall a time when the S&P 500 was this close to a high for the year but where there was this much angst on the part of investors? At one point, the Dow was down almost 170 points, with a 280-point range from sessions low to session high.

Yesterday, the Federal Open Market Committee left the fed funds rate unchanged at 0.25% to 0.50%, as expected. And the Fed’s economic forecasts are even more pessimistic now than they were just a few months ago. Fed chair Janet Yellen held a press conference and mentioned the weak labor market, low business investment and productivity, and concerns about a possible Brexit next week. The Fed’s own forecast sees U.S. growth topping out at 2% in the long run, well below the nation’s historic 3.3% growth rate. Looming in the background is persistently weak global growth. Today, other central banks delivered their policy messages.

The Bank of Japan kept monetary policy steady and lowered its inflation forecast, stating the consumer price index’s year-on-year change is likely to be slightly negative or flat for the time being. The yen surged against the dollar following the news, sparking speculation on whether Japanese policymakers would intervene to halt the strengthening currency, while the Nikkei tumbled 3.1%.

Reiterating its warning that the franc is significantly overvalued, the Swiss National Bank left its negative interest rates unchanged at record lows, conserving ammunition ahead of a British vote on EU membership. As expected, the SNB held its deposit rate at negative-0.75%.

The Bank of England kept its key interest rate at a record low of 0.5% and made no changes to its 375-billion-pound asset-purchase program. The decision marked the last before the June 23 referendum in the U.K. on whether the country should stay or exit the European Union. And the bank warned that a Brexit “could materially alter the outlook for output and inflation.”

“Leave” has surged to a 6-point lead in an important Brexit survey. A new Evening Standard newspaper poll, conducted by the reputable polling firm Ipsos MORI, shows that 53% of respondents favor Leave while 47% favor Remain. This was the first time a poll conducted by Ipsos MORI poll had favored Leave. But both sides of the Brexit campaign have temporarily stopped campaigning after Jo Cox, a Member of Parliament was shot and killed while meeting with constituents in a library. The motive behind the shooting is unknown but many people think it might be Brexit related.

Investors continued to buy up investments considered safe in times of economic uncertainty: United States government bonds, and stocks with high dividends. The yield on the benchmark 10-year Treasury note dropped to 1.52% in intraday trading; the lowest since 2012.

The number of people seeking U.S. unemployment benefits rose last week, but to a low level that indicates employers are still cutting relatively few jobs. Weekly applications rose 13,000 to a seasonally adjusted 277,000, the highest in four weeks. The less volatile four-week average declined slightly to 269,250.

Consumer prices, or prices at the retail level, rose 0.2% in May largely because of higher gasoline prices and rising rents. Although the cost of most goods and services aren’t increasing much, fuel has become more expensive. The energy index climbed 1.2% in May. Rents also jumped 0.4% in May to mark the largest monthly gain since February 2007. And they are rising at the fastest 12-month pace in almost nine years: 3.4%.

Overall price pressures are still muted, however, as the price of groceries dropped 0.6% in May, and prices are now down 0.7% in the past year. The consumer price index has risen just 1% in the past 12 months. The core rate that excludes food and energy has risen at a sharper but still low 2.2% annual pace.

Confidence among U.S. homebuilders climbed to a five-month high in June. The National Association of Home Builders/Wells Fargo builder sentiment gauge rose to 60 from 58. Home builders report cheap borrowing costs and steady improvement in the labor market have bolstered Americans’ abilities to buy homes. Builder sentiment in the West reached a five-month high.

The Philly Fed index rebounded into expansionary territory in June, with the headline index rising to 4.7 from -1.8. The key forward-looking indicators all moved in the wrong direction, with sentiment on new orders, employment, unfilled orders, inventories and capital expenditure intentions all weakening, while the hours worked sub-index remained firmly in contractionary territory in June.

Arizona’s seasonally adjusted unemployment rate increased one-tenth of a percentage point from 5.5% in April to 5.6% in May. The U.S. seasonally adjusted unemployment rate decreased three-tenths of a percentage point from 5.0% in April to 4.7% in May. A year ago, the Arizona seasonally adjusted rate was 5.8% and the U.S. rate was 5.5%.

Arizona lost 19,400 Non-farm jobs in May. Three of the eleven sectors posted gains, one remained unchanged, and seven sectors posted losses. The gains were recorded in Manufacturing, Construction, and Trade, Transportation, and Utilities.  The losses were recorded in Financial Activities, Information, Education and Health Services, Leisure and Hospitality, Professional and Business Services (-5,400 jobs); and Government (the big loser -13,100 jobs). Natural Resources and Mining remained unchanged.

Disneyland debuts in Shanghai. The theme park, which cost $5.5 billion and took five years to build, opened its doors today. Disney hopes it can tap into China’s growing middle class, as 330 million people live within a three-hour drive or train ride from the park.

California’s insurance commissioner called on the U.S. government to block Anthem’s $48 billion takeover of rival health insurer Cigna, saying the deal would limit competition in the state’s health-insurance market. While Commissioner Dave Jones doesn’t have legal authority to block the merger, his opposition, plus a 22-page letter he sent to the U.S. Justice Department, adds an influential voice to the debate. The takeover would give the combined Anthem-Cigna a greater than 50 percent market share in 28 counties in California, and a market share exceeding 40 percent in 38 counties.

Volkswagen  unveiled a major restructuring today, the broadest overhaul of the company in decades. VW announced plans to deliver 30 electric plug-in models by 2025. The product overhaul and pledge to cut $9 billion in spending come as VW is already facing a bill of more than $18 billion to cover the costs of its emissions scandal.

The company rigged some 11 million diesel cars worldwide with software to cheat emissions standards. The admission triggered a litany of government investigations, a U.S. sales slump, and a management shakeup. This also follows a mandate from the German government that as of 2030, all new cars registered in Germany must be emissions free. The plan is to add one million hybrid and all-electric cars by 2020 and 6 million by 2030.

After three successes, a leftover SpaceX rocket booster crashed Wednesday while trying to land on an ocean barge. In fact, the rocket’s failed landing was, according to a Twitter post by Elon Musk, “Maybe [the] hardest impact to date.” The attempt came minutes after the Falcon 9 rocket successfully launched two satellites into orbit from Cape Canaveral, Florida.

Facebook founder Mark Zuckerberg’s philanthropy venture has made its first major investment, leading a funding round in a startup that trains and recruits software developers in Africa. Google Ventures was also part of the $24 million funding round. The startup, which has nearly 200 engineers currently employed by its Nigeria and Kenya offices, will use the funds to expand to a third African country by the end of 2016.

Philadelphia is set to become the first major American city with a soda tax despite a multimillion-dollar campaign by the beverage industry to block it. The City Council is expected to give final approval today to a 1.5 cent-per-ounce tax on diet and regular soda, iced tea, energy drinks, juice drinks with less than 50% juice, and other sugary beverages.

Microsoft is getting into the marijuana business, announcing a partnership to begin offering software that tracks marijuana plants from “seed to sale,” as the pot industry puts it. The software is meant to help states that have legalized the medical or recreational use of marijuana keep tabs on sales and commerce, ensuring that they remain in the daylight of legality. But until now, even that boring part of the pot world was too controversial for mainstream companies. It is apparent now, though, that the legalization train is not slowing down: This fall, at least five states, including the biggest of them all — California — will vote on whether to legalize marijuana for recreational use.

Get ready, here it comes. An excessive heat watch has been posted for California and Arizona, warning of temperatures that could hit 119-degrees this weekend. The forecast calls for record highs and record high-lows. High lows can sound a bit funny to say but what they translate to is misery: Temperatures stay so warm overnight that there is little relief from the heat even after the sun has set. The only consolation is that we are not expected to break the all-time record high of 122-degrees from June 26, 1990. Small consolation.