Bond Market Commentary
Identify Economic Factors That Impact the Bond Market and Current Fixed Income Strategies
By Doug Drabik
April 25, 2022
The current market volatility and conditions have influenced a shift to individual bonds. Today’s commentary recaps some of these influencing market conditions.
- The markets are volatile because risk levels are elevated in several major economic and worldly categories including: Geo-political events, commodities, supply chain, central bank activity and consumer spending. Probabilities are numerous giving to lots of viable outcomes. This explains the market volatility and the wide range of year end forecasts.
- Geo-political events include a war in which even Russia is surprised by its length and world reaction. This lingering event has collateral damage affecting oil distribution, currency reliance and nuclear weapon concerns. Covid-19 continues to subsist as a pandemic with resilience. This pandemic is the epicenter of business shutdown, supply problems, disrupted employment and globally altered fiscal/monetary policies.
- These events have spilled into commodities. Oil prices have risen dramatically creating inflation at the gas pump. Food, other staples and nearly all products are affected by increased transportation costs.
- The supply chain issues also persist. Ports are still bottlenecked. Retail methodology is changing in many cases from just-in-time inventory to warehousing surplus, much like many consumers who have taken to hoarding certain household products. There is a looming larger material shift cueing deglobalization of manufacturing. The pandemic exposed weaknesses in domestic well-being when reliability on foreign pharmaceutical supply, key manufacturing parts and other crucial production resources were uncovered.
- Central Banks retain bloated balance sheets. Four major central banks (Federal Reserve, European Central Bank, Bank of Japan, People’s Bank of China) hold a combined $30.9 trillion on their balance sheets. For years, the money injected into the economy has propped up asset prices. In other words, asset inflation has existed for nearly a decade. It is only recently that inflation for goods and services has crept into the economy.
- Global interest rate disparity continues. Although interest rates have risen across the globe, the disparity between the U.S. and most of the European and Asian interest rates inside of five years has widened further. This helps support the theory that the U.S. Treasuries inside of five years are oversold. Much of the Treasury curve forward positioning is in response to the Fed’s declaration of moving Fed Funds into a more neutral position (2.25%-2.50%).
- In the opinion of this author, the Fed could raise interest rates today by 100bp and it will have little immediate impact on this inflation. Supply chain issues (especially in light of deglobalization) are not a short term fix. Eventually, we will solve the issue, just not overnight. Wage inflation will not be alleviated with any monetary policy move. It is likely that inflation may lessen but at higher than ideal levels throughout 2022. The good news is that the Fed, by moving into a neutral rate position, will be better positioned to be able to react in either direction down the road when policy will have a greater impact.
- Previous Fed tightening cycles (raising short term rates) have flattened the Treasury yield curve.
- Pundits argue that recessions tend to be preceded by inverted curves but that inverted curves don’t always end in recessions. In my opinion, this is a technicality, not a reasonable observance. Over a sensible date range, the curve may invert and then go positive and oscillate in this pattern for some time. Technically, the day(s) of inversion didn’t immediately turn into a recession but when stepping back and looking at the range of dates when a majority (not all) reflected an inverted curve, within 13-24 months, a recession ensued.
- There are key ways out of the enormous debt (~$8.9 trillion) the nation has accumulated. The ideal method is through growth. Most economists have pulled back end of year growth projections. Inflating our way out is sometimes discussed. Although inflation reduces the real value of debt, it increases the nominal government cost (cost of servicing this debt) and eventually leads to higher wage demand. Austerity or trimming government expenses is also a way to reduce debt but this administration is talking about adding large infrastructure spending. The last plausible way is raising taxes, which is usually an unpopular choice. The reality is that some combination of these will likely be the path.
- As 70% of our nation’s GDP is composed of consumer spending, it is an important data point. Consumer spending tanked at the beginning of the pandemic. After stay-at-home employment flourished, helicopter money was distributed by the government, student-loan payments were suspended and rent payments were deferred, consumer spending spiked in late 2021 and has stayed somewhat elevated to date. As all these conditions unwind, it can be argued that spending will tail off.
- A two-fold fixed income benefit has developed. Year-to-date, Treasury yields are up extensively: the 2 year Treasury is up 188bp and the 10 year Treasury is up 131bp. At the same time, corporate spreads have widened. By example, the 10 year BBB Corporate Spread index has gone from 120bp to 172bp. 10 year municipal yields as a percentage of 10 year Treasury yields have risen from 65.2% to 92.7%. Higher Treasury rates plus higher spread/yield relationships mean much higher corporate and municipal yields.
- When statements are made about a flat curve, generally the reference is to a flat Treasury curve. Corporate and municipal curves are appreciably steeper than the Treasury curve therefore they provide more yield reward for extending out on the curve.
- For more detail about any of these bullets, including graphs or charts that help support this data, contact your Raymond James financial advisor.