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June 7, 2015

The First Bond Market 3-day Spike in 4 Years

Yields on the benchmark 10-year Treasury note jumped by 27 basis points (0.27%) over the first three days of this week. Driehaus Capital says this was only the second such three-day spike since the fall of 2011. Speculation about the timing of the first interest rate hike by the Federal Reserve and a rise in European bond yields are both contributing factors.
This year is showing signs of being a sequel to 2013. Since reaching a short-term closing low of 1.85% on April 17, yields have risen to 2.31% as of this afternoon. In 2013, yields rose from 1.63% on May 2 to 2.14% on June 4, 2013. The 10-year Treasury note event eventually ended 2013 with a yield of 3.03%.
Nobody knows with any certainty where yields are headed over the forthcoming seven months. Though this year’s jump is swift and reflects speculation about the timing of a change in monetary policy, like the move two years ago, there is never a guarantee of history repeating. Even the voting members of the Federal Open Market Committee (FOMC)—in aggregate—seem uncertain about when rates should be raised.
The chatter about the direction of future of monetary policy is too narrow in scope. While a change to a tightening stance by the Federal Reserve would be a notable event, focusing solely on the timing of the first rate increase is akin to completely missing the elephant standing smack-dab in the middle of the room. What matters is not so much the timing of the first rate hike, but rather what comes after it. Will the Fed make symbolic rate increases or will it undergo a series of hikes pushing up rates notably higher? The answer to this question, like the answer to the preceding question, is “data dependent.”
There is a second elephant in the room to be aware of: bond liquidity. Liquidity, in this case, refers to how easy it is to buy and sell securities. As basic economic principles state, whenever there is a disproportionate number of sellers to buyers, prices will drop. (Prices and yields are inversely related, so as prices drop, yields rise.) An imbalance between buyers and sellers is being blamed by some for helping to cause the recent jump in bond yields. Whether this is a full-grown elephant or a baby elephant is hard to say, especially since liquidity is relative to the type of bond being discussed. Treasuries enjoy a large and active market, while corporate and municipal bonds can experience far less trading. Nonetheless, even concerns about a liquidity crunch can lead to volatility.
The monetary policy and liquidity elephants can be ignored by those who currently own actual bonds and have the intention of holding them until maturity. There simply is no reason to react as long as the issuers can reasonably be expected to fulfill their obligations. Those looking to buy bonds may find more attractive prices due to the recent move in bond yields. Bond fund investors—a group that includes me—will endure price volatility. Given the move in bond yields (which reduces prices), it would not surprise me to see negative second-quarter returns for bond funds [mutual funds, exchange-traded funds (ETFs) and closed-end funds], barring a complete reversal in yields over the next few weeks. That’s okay. We’re hiring bond managers to guide our fixed-income dollars through a variety of market environments. When potholes appear, the ride will be bumpy. It’s inevitable.
Those of you are nervous should keep a few things in mind. First, calls for when the FOMC will begin raising rates have been and continue to be premature. At some point they won’t be, but this threshold has not been reached yet. Second, the timing and magnitude of future rate increases is an even bigger unknown. Furthermore, nobody knows what the yield of the 10-year Treasury note will be at the end of this year, much less what it will be at the end of 2016 or even further out into the future. Even those who claim to have insight don’t know. Third, if you hold a bond (an actual bond, not a bond fund) to maturity, you will receive the par value of the bond, plus you will be paid interest no matter what happens to the bond market. Finally, over the long term, bond returns have been uncorrelated to stock returns. As such, bonds can smooth out the overall volatility of a diversified portfolio.
The Week Ahead

It’s going to be a fairly quiet week in terms of what’s on the calendar. H&R Block (HRB), which reports on Monday, will be the only S&P 500 member to announce earnings.
The week’s first economic report of note will be the Labor Department’s April Job Openings and Labor Turnover (JOLTS) Survey, released on Tuesday. Thursday will feature May retail sales, May import and export prices and April business inventories. The May Producer Price Index (PPI) and the University of Michigan’s preliminary June consumer sentiment survey will be released on Friday.
The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)  
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle
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