Bond Bear: Listening to YellenJune 1, 2015 12:00 am
Several colleagues and I had the good fortune to attend Federal Reserve Chair Janet Yellen’s speech sponsored by the Greater Providence Chamber of Commerce on May 22nd. For many people, listening to a dry, formal presentation on the economy would not be an exciting event. But for me, it was. Yellen is, after all, often called the most powerful woman in the world. And she was talking about a topic that is critical to our clients’ portfolios – interest rates. But more than wanting to hear this influential woman speak; I was there to listen to her tone.
Headlines have declared for several years that the thirty year old bond bull market was about to end and would be signaled by rising interest rates. There have been a number of false starts to rate increases during this time, as the bond market itself likes to zig and zag in anticipation of the Fed’s moves or in reaction to various pronouncements or data. The 2013 bond temper tantrum is a perfect example of bond investors jumping the gun on rising interest rates, only to experience a subsequent year of falling rates. The last ‘zig’ was from April 17th to May 12th of this year when the ten year treasury bumped up almost fifty basis points before erasing half of that increase.
Bond sell offs can be fast and furious – especially on the long end of the curve, so when the bond bear market really kicks in, volatility could be much greater than what many people are used to. In early May Yellen warned of “a sharp jump in long-term rates.” At the same time, she and her team are looking at ways to subdue this type of market reaction.
The mantra of the Fed for the last few months has been “hike soon, go slow.” “Hike soon” because artificially low rates contribute to the burgeoning $4T Fed balance sheet and are being blamed in part for the rise in asset inflation and income inequality. More importantly, they aren’t the norm and could make it difficult to counter inflation when it returns. So the Fed needs to start raising rates as soon as the US economy is strong enough.
But “go slow” is equally important since rising rates also have consequences. As interest rates increase, the price of bonds falls, meaning that existing bonds are worth less to their owners. And the Federal Reserve’s balance sheet itself becomes more expensive. In addition, stock prices can drop as well, as many investors believe the equity markets have been artificially propped up by Federal Reserve policy.
History shows that markets internalize slower tightening cycles much better than faster ones. Increased company earnings and improved labor productivity can outweigh moderate increases in borrowing costs and compressing profit margins, and interest rate coupons can help to balance out a gradual fall in bond prices. In addition, the long end of the curve, which is not controlled by the Federal Reserve, may be spooked less by inflationary fears if rate increases are gradual.
Unfortunately, the last seven of eight tightening cycles have been fast – meaning that interest rate increases followed each other in rapid succession. That led, at times, to more volatility in market performance, setting up the expectation that this tightening round will be no different.
Janet Yellen begs to differ. It is the Federal Reserve’s job to retrain investors on what they can expect when this bond bull turns into a bear. She chooses her words very carefully in an effort to be as transparent as possible.
I listened very closely to what Janet Yellen had to say during her recent speech. But I also listened to how she delivered her message. Tone matters. It shows the level of conviction someone has to what they are saying.
Yellen was calming and she was confident. And there was determination in her voice that can’t be seen when reading the text of her speech. I left the presentation without a doubt in my mind that she wants to raise interest rates this year. And that she is committed to making this tightening cycle very different from those in the recent past – much slower and much more measured. I have the sense that she will not be rushed, especially by the markets.
While Janet Yellen is limited on what she can do to influence investor expectations and market dynamics, it would be very beneficial if investors paused long enough to listen to this messenger and heeded her advice to move slowly.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.