While traders continue to focus on the near-term issues including the OPEC meeting, the vote in Italy, and all things Donald Trump, my team is looking ahead to next year from a macro perspective. And the key questions in our minds isn’t whether the new administration is going to cut taxes (they will), initiate a fiscal stimulus program (they will), and/or reduce regulatory burdens on banks (yea, they will likely do that too). No, the big question is whether or not the bond market is experiencing a sea change.
To review briefly – and as I spelled out yesterday – bonds have been in a mega-bull market for something on the order of 35 years. And since the “Taper Tantrum” move ended in mid-2013, bond investors have enjoyed a very nice cyclical bull ride as the yield on the 10-year fell from about 3% to 1.367% in July of this year.
But as the chart below clearly shows, rates have spiked since the all-time low set in July and the question now becomes, how far can rates rise?
Yield of U.S. 10-Year T-Note – Weekly
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Before I go any farther, let me be clear that what follows is an uber-big picture view of the world. As such, the analysis below is unlikely to make anybody any money in the near-term. And frankly, from a short-term perspective, bond prices are oversold and due to bounce.
But from a macro perspective, I see seven reasons to perhaps take a second look at the way one views the bond holdings in their portfolios (more on this tomorrow).
It’s the Economy…
While the glass-is-half-empty crowd doesn’t want to admit it, the U.S. economy appears to be gaining momentum. Yesterday’s GDP report and the ongoing strength in the jobs market would be Exhibits A and B in this argument. Then when you factor in the market expectations for the Trump administration’s plans, well, there is really no argument for interest rates to fall. In reality, it is just the opposite. ‘Nuf said.
Unlike the stock market, the bond market doesn’t trade on emotion. No, bonds focus more on math and the discounting of future cash flows. A key component in the bond game is expectations for inflation. The bottom line here is that if inflation is expected to rise, bond yields tend to rise as well. So, with nearly every central banker in the world trying to create inflation in their countries, one has to assume that inflation is going to increase – at some point. And don’t look now fans, but our inflation models have been rising for months now. The question, of course, is what level inflation will rise to. This remains something to watch VERY closely.
Fiscal Stimulus on the Way
Regardless of whether or not you agree with the Trump administration’s views, the key is to recognize that fiscal stimulus coupled with tax cuts are likely coming down the pike. And the assumption is that this will be the one-two punch the economy has needed to finally reach “escape velocity” and move forward at a healthy clip. If this is your view, then you must also expect to see higher inflation, which, leads to, yep; you guessed it – higher rates.
More Supply on the Way
A side effect of the expected fiscal stimulus plan is the fact that you have to somehow pay for it. And the assumption is that the Trump administration will have to increase the deficit to fun the rebuilding of roads, bridges, airports, etc. This will cause more bonds to come to market. And with the Fed out of the QE game, the thinking is that this increased supply will cause rates to rise at the margin.
Global QE Winding Down
Although I am generalizing here and it is tough to follow the actual money trail, when global central banks like the ECB and the BOJ “print money,” (a term I’m using loosely) it has to go somewhere. And the general consensus is that a fair amount of that fresh capital being printed in Europe and Japan tends to wind up in the U.S. bond market. But with the ECB’s QE program set to expire in 4 months, the argument can be made that there will be less demand for bonds at auction. And this, as you might suspect by now, could also cause rates to increase.
There can be little argument that Ben Bernanke and the Fed needed to pull out all the stops during the credit crisis of 2008. However, housing has now recovered. The jobs market is strong. The economy has recovered. And inflation is currently at the Fed’s target. So, while Janet Yellen doesn’t want to act swiftly or upset the apple cart here, she and her merry band of central bankers will continue to “normalize” monetary policy in the U.S. In English, this means they will work to return the Fed Funds rate to a more “normal” level. Granted, no one expects to see Fed Funds at 3% any time soon, but that would be a more normal level. And with rates expected to be increased to 0.50% in December, well, the Fed could be in a rate-rising mode for some time.
And finally, there is a little something called “money flow.” But first, it is important to recognize that thanks to Dodd-Frank and other regulations, generally speaking, the liquidity in the bond market is a fraction of what it was pre-crisis. What this means is that like stocks, when there is an “event” bond prices move much more swiftly than the once did. The point is that if (a) the “great rotation” (a term used for the mass movement of money from bonds to stocks) actually begins to roll and (b) there are liquidity issues in the bond market, bond prices could fall.
The important thing to keep in mind here is that this “great rotation” isn’t likely to happen all at once. In other words, every investor isn’t going to wake up on January 1, 2017 and decide to move 10% out of bonds. But this is the type of move that could become very popular if ANY of the above starts to occur. And it doesn’t take a PhD in finance to understand that if more people are selling than there are people buying, prices tend to fall.
Tomorrow, we will look at the actions we are taking now as a firm and what we are considering doing going forward.
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of the “Trump Trade”
2. The State of Global Central Bank Policies
3. The State of Interest Rates
4. The State of Global Economies
Thought For The Day:
What it lies in our power to do, it lies in our power not to do. -Aristotle
Wishing you green screens and all the best for a great day,
David D. Moenning
Chief Investment Officer
Sowell Management Services
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