Bonds – “Don’t Fight the Fed”
Posted by Barry Simson on January 27, 2013
There is an old saying among bond traders: “Don’t fight the Fed”. The meaning of this saying is that the Federal Reserve has a lot more financial resources than ordinary mortals or financial firms. So if the Fed wants rates to stay low, rates are going to stay low. The Fed continued with its various programs and asset purchases during 2012 and carried them into 2013. Purchases currently total between $80 and $85 billion per month in securities, generally split fairly evenly between treasury securities and mortgage backed securities (MBS). Rates generally stayed in a fairly tight trading range during 2012, up a little, down a little.
Despite the low rates, the economy is still just above “stall” speed. Employment statistics are not good despite the official unemployment rate being lower. The participation rate of those who wish to be employed is the lowest in 30 years even if they have dropped off the official unemployment statistics. Housing has picked up, which is a plus. Due to uncertainty and a weak economy, business investment has been low. Taxes have increased on those well-off families regardless of whether or not it is fair or good for the economy. Social security taxes have increased to previous levels on all those employed which is likely to cause a cutback in consumer spending. Despite making it past the fiscal cliff, there is still uncertainty about what the clowns in Washington D.C. will do next. All in all, the economy appears as if it will muddle through at below average growth rates.
The market uses interest rates as a signal. The level of rates is one of the signals that the economy uses to allocate resources to various sectors of the economy. Rates rise when the economy is strong, when inflation is rising, or when government debt levels are too high. Rates fall or stay low when the economy is weak, when inflation is subdued, and when the government is careful with its debt levels. When the Fed is causing rates to be artificially low, then market signals of impending problems may not be seen or bubbles may develop. People and businesses change their behavior in ways influenced by the artificially low rates often times causing a bubble. By definition, a correction after a bubble is painful.
One signal being distorted is something we call the real rate of return. This is the return on your bond after accounting for the effects of inflation. Over the past 20 years, the average yield on a 10 year treasury note was 226 basis points (bp) more than inflation measured by the Consumer Price Index. During 2012, that measurement averaged -38 bp. If you invested in a 10 year treasury note at the beginning of the year, you would have earned less than the rate of inflation. From a market perspective, it sends three signals. The first two are that either treasury rates need to rise or that inflation needs to fall, or a combination of the two. A negative real investment return is not going to continue for long. The third signal it sends is for investors to look for more attractive investment opportunities, ones that have a better chance of outpacing inflation. To get those better returns, a choice between longer maturities, higher risk or a different asset class needs to be made. For many, the answer may be to invest in dividend paying stocks that provide a current return similar to bonds but with the opportunity for growth over time.
For 2013, the question is where will rates go next. Rates could stay low for this year or longer as the economy is slow and the Fed keeps holding them down. However, given the current negative real returns, without the Fed’s intervention, the expectation would be that rates would probably rise somewhat. Last year we described our PIIGS R US scenario which causes rates to rise significantly as a result of ongoing fiscal deficits. This scenario is a repeat of the European budget crisis, only here in the U.S. While there has been some talk about reforming our deficits there has been no action on it so far. We do not count the $6 billion annual tax increase on higher earning families as action when the deficit is over $1 trillion per year. Nor have we counted the automatic spending cuts that were scheduled to occur on the 1st of this year but have been put off once so far. There are likely to be additional rating downgrades this year from one or more of the bond rating agencies. We believe PIIGS R US will occur but the question is when? It could still be several years away. In the meantime we do not want to “fight the Fed” while they are holding rates lower; however, we will bias our actions toward shorter fixed income portfolios with the anticipation that at some point the Fed will change its stance with the likely result of rates rising.