Perspective on global economic and fixed income developments

The remarkable resiliency of U.S. bonds

Summer 2017

Key takeaways:

  • In spite of multiple Fed rate hikes, the yield on the 10-year Treasury is about where it was at the end of 2015.
  • If this doesn't underscore that longer-term bond yields don’t have to rise when the Fed hikes rates, we’re not sure what would.
  • The lack of financial market volatility amid the geopolitical upheaval seems surprising, and we don't think it can last.
  • As long as yields on bonds from other G7 countries remain below Treasuries, it's another reason why U.S. bond yields may remain lower for longer.

Who would have guessed that President Trump’s first five months in office would be so filled with drama and intrigue? Yet as unprecedented as the political environment has been, the present state of the financial markets—and fixed income market in particular—may seem like an even bigger surprise. President Trump’s campaign promises for tax cuts, infrastructure spending, and deregulation sent consumer confidence soaring earlier this year, pushing stocks to record highs amid hopes for a range of economic stimulus. However, the reaction of the bond market is another story altogether, with yields on 10-year Treasuries recently returning to about where they were when this year began.

An unfortunate series of events

Consumer sentiment surged early this year, as investors rallied behind the Trump Administration. Then the president ran into a series of political setbacks. From challenges regarding a proposed travel ban, to failed initial efforts to reform health care, to problems surrounding a former FBI Director, to the Russia controversy, President Trump's first 100 days in office ran into plenty of roadblocks. All of this called into question whether the president's proposed tax system overhaul would be achievable and whether fiscal-spending initiatives, whenever they finally arrived, would be anywhere near as robust as touted. This also called into question whether the U.S. economy would be able to speed up to the 3.0% annual pace promised by President Trump. After all, if health care is taking this long to reform, how long will the president’s more politically entrenched tax reform efforts take?

A politically charged atmosphere

The political atmosphere in the U.S. seems surreal. Amid the shifting landscape, where is the U.S. economy headed from here, and will the Fed continue to raise rates? Will long-dormant inflation accelerate in light of the falling unemployment rate and propensity for wage-inflation pressures to build? Or, has forward economic progress stalled, which could keep inflation in check? Will international economies continue to recover, and will overseas central banks follow the Fed and start to normalize interest rates this year? In short, we know that advisors and investors alike have many questions about the current environment, and we address many of these issues in this edition of our insights.

Political uncertainty ≠ financial market uncertainty

In the December 2016 edition of our quarterly insights, we suggested that advisors prepare their clients to expect the unexpected in 2017 and focus on fundamentals. We also mentioned that the initial spike in bond yields after President Trump was elected seemed unlikely to continue this year. After all, the obstacles for the new administration were formidable, and the best-case achievement of those objectives was increasingly priced into valuations for stocks and bonds. Based on where we’re at currently, our expectations seem to be playing out.

 

What comes as a surprise amid all the geopolitical upheaval is that market volatility has been virtually nonexistent.

The fearless financial markets

What comes as a surprise amid all the geopolitical upheaval is that market volatility has been virtually nonexistent. From our perspective, that’s quite unexpected and won’t last. It also feels a bit foreboding because the relative calm seems like a reflection of desensitization to the seemingly endless series of Trump-related headlines. One of the financial market’s most widely used "fear gauges" is the Chicago Board Options Exchange volatility index—CBOE® VIX®. Near the end of June, the VIX was around 11%, which is historically low and about half where it was just days before last year’s presidential election. This is illustrated in the chart below, which demonstrates how equity market investor concerns have been trending lower over the past year. Similarly, measures of bond market volatility are also benign. Clearly, political volatility doesn’t have to translate into financial market volatility.

CBOE VIX

Tame inflation means lower yields

Contrary to what investors might think, longer-term bond yields haven't skyrocketed this year. After rising to roughly 2.60% in early March—when consumer confidence was near its recent zenith—10-year Treasury yields fell to around 2.15% by mid-June. That’s an impressive result, given that the Fed hiked short-term rates twice during that period. More impressive still is that in spite of the Fed raising short-term interest rates by a total of 1.0% since mid-December 2015, the approximately 2.30% yield on the 10-year Treasury as of mid-July is near where it was at the end of 2015 and 2016 (see the chart below). Let that sink in for a moment! If this doesn’t underscore that longer-term bond yields don’t have to rise just because the Fed hikes rates, we’re not sure what would.

10-year Treasury yields

For intermediate- and longer-term bond yields, it’s all about inflation and growth expectations. And by just about any measure, inflation is quiet, while growth has only been moderate. Janet Yellen’s mid-June testimony stated that the Fed is worried that wages will rise if the unemployment rate stays below 4.5%. Her contention is that this will translate into increased demand for consumer goods, and ultimately faster inflation.

It’s entirely possible that the Fed will raise rates one more time this year for the sake of getting interest rates closer to normal.

We’re less convinced that wage inflation pressures will actually emerge. We believe that it's entirely possible that the Fed will raise rates one more time this year, primarily for the sake of getting interest rates closer to normal. Yet unless inflation becomes a tangible concern, we believe that it’s also entirely possible that the Fed will be on prolonged policy hold from there. Moreover, this is precisely what federal funds futures currently predict.

Plans to unwind the Fed's balance sheet

At its mid-June meeting, the Fed talked about paring back the Fed’s $4.5 trillion dollar balance sheet to more historically appropriate levels. Based on Janet Yellen's testimony, the Fed plans to employ a relatively seamless process of unwinding their balance sheet, rather than have this act like a rate hike surrogate with an accompanying "taper tantrum" that would drag on growth.

Final takeaways

So what are the final takeaways with this backdrop in mind? As we’ve mentioned repeatedly, advisors would do well to remind their clients to expect the unexpected. Particularly in light of the disconnected nature of stocks and bonds at the moment, maintaining a well-diversified portfolio makes eminent sense. Treasuries in particular can help balance the stock portion of a portfolio when it needs it the most.

As we’ve also mentioned before—and as this year’s bond market behavior emphatically demonstrates—longer-term bond yields don’t have to rise just because the Fed is hiking rates. On the contrary, such preventative moves to keep inflation under control can put a lid on inflation expectations, which is usually the primary driver of longer-term bond yields. Additionally, the Fed is now far closer to achieving interest rate “normalcy” than two years ago—they may even be done raising rates for a while.

In addition, global bond yields are supporting U.S. bonds, particularly Treasuries. As long as Group of Seven nation bond yields remain generally lower than similar-maturity Treasuries, it’s just one more reason why yields on U.S. bonds are likely to stay lower for even longer.

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