Perspective on global economic and fixed income developments

Bonds: Can't live with 'em, can't live without 'em

Spring 2017

Key takeaways:

  • Ever since the November election, most everything that President Trump has done, said, and tweeted has affected the financial markets.
  • Despite the second Fed rate hike in roughly three months, longer-term interest rates have remained in a fairly tight range.
  • An unprecedented president, unprecedented markets, and uncertainty surrounding interest rates are undercurrents that could lead to continued market volatility.
  • Fixed income securities can provide critical benefits, especially during uncertainty, but overstretching for yield can potentially sabotage the ballast that bonds can provide.

Only a couple months into his official tenure, Donald Trump has been busily redefining expectations of what it means to be the U.S. president. Trump’s unprecedented approach has caused just about everything that he has done, said, and tweeted to be captured by the media, taking the financial markets along for the ride. When he has talked about trimming corporate taxes and reducing regulations, equities and bond yields have risen amid expectations for greater corporate profits, faster U.S. economic growth, and an accelerated pace of rate hikes. Stocks and bond yields have also risen when Trump has talked about spending on infrastructure, reflecting expectations that this would boost growth. However, when Trump has talked about tightening immigration standards and increasing import taxes on trading partners like Mexico, the opposite has occurred, with equities and bond yields falling amid worries about potential trade wars and currency market volatility.

Market divergence

As the chart below shows, longer-term Treasury yields are down quite a bit from their mid-March levels, and down modestly as well as on a year-to-date basis.

Given all of Trump’s plans, the ongoing equity bull market, stronger jobs numbers, lower unemployment, and the Fed’s March rate hike, you’d expect that longer-term bond yields had skyrocketed this year. In fact, that’s not the case at all. It’s true that yields have moved around amid a variety of market undercurrents, particularly those caused by the Trump Administration.

Yet as the chart below shows, longer-term Treasury yields are down quite a bit from their mid-March levels, and down modestly as well as on a year-to-date basis. For example, 10-year Treasuries yielded around 2.40% as of the end of March, compared with approximately 2.45% at the end of 2016.

Treasury Yields

Platform promises and bond yields

Bond yields rose early this year in part because Trump’s platform promises seemed likely to drive up inflation. However, the new administration’s inability to pass significant health care reforms called this possibility into question and illustrated how difficult it might be for Trump to deliver. Even though he has a Republican majority in both the House and Senate to help pass measures, it’s tough to get anything done in Washington. So banking on substantial industry reforms, a huge fiscal spending package, and significant corporate tax reductions by early this year was a really tall order. In addition, some of Trump’s proposed policies—like building a wall and increasing taxes on U.S. trading partners—could even counter some of the economic benefits of any fiscal stimulus that he manages to enact. Amid this backdrop, it makes sense that bond yields aren’t sharply higher than at the start of 2017.

The Fed: A whole new game plan

With the media frenzy focusing on Trump, the Fed sometimes fades from the spotlight. However, this all changed recently. Fed Chair Janet Yellen’s dovishness was a dominant theme keeping U.S. interest rates low for what felt like forever. Furthermore, until the start of this year, the Fed was remarkably consistent about telegraphing their plans for interest rates in just about every meeting we’ve seen over the past decade.

The Fed’s communications leading up to their March rate hike deviated from this pattern. It seemed like almost overnight, the Fed changed from not wanting to raise rates at their March meeting, to deciding it was time to hike rates. The sentiment shift seemed to start about mid-February, around the time that Yellen testified on Capitol Hill regarding the state of the U.S. economy. She didn’t sound dovish at all. Instead, her testimony painted a picture of healthy U.S. economic growth and significant progress toward the Fed’s dual mandate of price stability and maximum employment. Yellen’s subsequent speaking engagements reinforced the notion that a March rate hike would likely be appropriate. This sudden change in rhetoric put the markets on high alert, indicating that when it came to rate policy, anything was possible.

So where do rates go from here?

Although the Fed could ratchet the federal funds rate a bit higher this year as they continue to “normalize” their policies, more than two additional hikes in 2017 seem unlikely. In addition to continued labor market strength and evidence that inflation is building, we’d also need to see tangible evidence that Trump can deliver on his political agenda. Until then, fiscal stimulus talk seems to lack any real substance. In other words, a lot still needs to happen for bond yields to rise significantly.

If the Fed does raise rates again soon, longer-term bond yields may nevertheless fail to rise significantly. It’s important to remember that a short-term rate hike doesn’t necessarily mean that yields on longer-term bonds have to rise correspondingly. For illustration, just look at where yields headed shortly after the Fed’s rate hikes in December 2015 and 2016, depicted in the charts below.

Falling bond yields

In the weeks following the Fed’s rate hikes in December 2015 and December 2016, 10-year Treasury yields actually fell.

Bond yields

History doesn’t have to repeat itself—later this year, or ever—but that doesn’t mean it can’t, either. Longer-term bond yields are driven by inflation expectations, and yields on these securities could even fall if the Fed raise rates again, as this would show that the Fed was proactively jumping out in front of inflation.

Longer-term bond yields are driven by inflation expectations, and yields on these securities could even fall if the Fed raises rates again.

Lesson to learn

If there’s a lesson to learn, it’s that we'd be wise to expect the unexpected. Unlikely, unforeseen, and completely off-the-radar events occur all the time. Markets, politics, and economies all progress and evolve in ways that are difficult to predict. Trump’s Election Day victory was quite a shock to many. Similarly, when Brexit became a reality last year, it too was a shock. Both Trump’s win and Brexit were statistically unlikely, but not hugely so, they just seemed that way. Why then were investors so shocked when these events occurred? Collectively, we seem to view unlikely events as impossible, and correspondingly, perceive likely events as certainties. In reality, it’s probably all much closer to somewhere in between.

With these points in mind, it’s worth remembering that bonds can provide a stabilizing effect to portfolio volatility. Historically, whenever things looked bleak, fixed income strategies tended to outperform equities, especially if a flight-to-quality had ensued. Also, it’s important to avoid replacing higher-quality bonds with lower-credit, higher-yielding bonds to generate more income. Such a strategy poses considerable credit and equity market correlation risks, and if these risks are ignored, an investor’s portfolio could fail to provide critical ballast when it might need it the most. Moreover, high-yield bond yields are historically low right now, so moving down the ladder in credit quality could mean taking on additional risk without necessarily getting a big jump in yield. Therefore, we believe that high-quality bonds should always be part of a portfolio. After all, Brexit continues to make waves in Europe and the Trump presidency is an enormous risk factor. So expect the unexpected, and remember the benefits that bonds can provide.

Brett signature

Brett Wander, CFA
Chief Investment Officer, Fixed Income
Charles Schwab Investment Management
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