April 17, 2014

Closing Comment

Bonds have closed for the day, and for the rest of the week. Whatever angst the stock market has been feeling this week finally rubbed on bonds today. Bonds had been sailing along quietly while equities bobbed and weaved lately, but somewhere in the middle of the shortened day a storm arose and bond prices sank.

At day’s end, we find the 2-year at 0.40% (-2/32), the 5-year at 1.73% (for a loss of -13/32), and the 10-year at 2.72% (dropping -25/32 today). The star of the week until today had been the 30-year, but it stumbled today with a price erosion of -1 point and 12/32 to produce a yield of 3.52%. These are pretty impressive losses for one day.

No one seems to have an explanation for this sudden loss of appetite to own fixed-income paper. True, jobless claims remained low, but nothing dramatic. The Philly Fed Index was stronger at 16.6, but that alone shouldn’t have spooked bond traders. Equities have a small bid at the moment, but that shouldn’t have been enough to generate a batch of sell tickets. The one idea that may explain things is that the liquidity in the bond market was minimal today and one big sell order could account for a cascade of activity around the street. We won’t know this until bonds open on Monday. There is also the chance that the weekend meeting in Geneva between all of the parties in the Ukraine conflict will produce some tangible results, and the flight-to-quality traders were feeling less fearful.

Enjoy the Easter break.

Morning Comment

Just a quick housekeeping note: Bonds are closing early today (2:00 PM Eastern) and will be closed all day tomorrow in recognition of the Easter weekend. Liquidity is going to dry up fairly early today. Keep this in mind if you have any investing to do.

Initial jobless claims remained on the soft side with a total of 304k seen last week. The prior week’s report was 302k. These numbers point to continued job growth to be reported in upcoming non-farm payrolls in the months ahead. Now if we could just turn this data into increased wages for the poor working stiffs in America.

Equities had a good day yesterday. There was some upward follow-through in Asian stocks overnight, although Japan’s Nikkei closed unchanged, failing to extend the huge gain of +3.0% the day before. European stocks are pushing higher. U.S. equity futures are pointing to additional gains when regular trading gets underway today.

The uptick in equities is happening even with disappointing results from American Express, Google, and IBM announced after markets closed yesterday. Those stocks are individually lower but the rest of the market seems to want to go higher.

Bond prices are lower today. The 2-year is opening at 0.38%, the 5-year is 1.67%, and the 10-year is 2.64%.

The real story is the shape of the yield curve more than the absolute level of rates. I wrote in my closing comment last night that the 30-year bond yesterday made new lows in yields for all of 2014; in fact, the 30-year bond is back to yields not seen since the middle of 2013 (in the middle of the taper tantrum). I took a look at the average yields of various spots on the curve since June 18, 2013, with some surprising results: the 2-year average yield over that stretch is 0.35% (compare to this morning’s yield of 0.38%), the 5-year note had an average yield over that stretch of 1.51% (compare to this morning’s yield of 1.67%), the 10-year had an average yield of 2.71% (compare to today’s 2.64% level), while the 30-year bond was the clear winner with an average yield of 3.70% since June 18, 2013 (compare to today’s level of 3.44%). Hard to believe that after all we’ve been through rates are still pretty close to their average levels going back nine months!

However, the 5-year is clearly bearing the brunt of the selling pressure in recent days. The 5-year yield is visibly higher over the last months while other yields are the same or lower. Investors are not shunning fixed income investments altogether, rather they are being more selective. A plausible explanation of this behavior could be that investors recognize that the Fed will have to exit its accommodative ways at some point (meaning rates will go up), but listening to Fed Chair Yellen one could reasonably conclude that any tightening is going to happen no sooner than 2015. One can own 2 and 3-year paper with little market risk (or so goes the logic of this argument). However, the fact that the 5-year will still have duration remaining when the Fed finally does have to tighten means that it is vulnerable to market risk. If all goes according to plan, the 30-year bond can benefit as any sort of Fed tightening will cool future economic growth and keep a cap on inflation. At least that’s one way to look at it.

The other thing the bond has going for it is the enormous yield spread between it and the short end of the yield curve. I would argue that this spread is artificially wide because of the Fed’s zero interest rate policy being in effect for going on 5 years now. Until the Fed allows the market to seek its own level of interest rates I think it is a little dangerous to assume that today’s wide spread might not be all that predictive of future behavior. And if inflation were to return sooner and at a faster clip than the Fed currently expects the bond market might have a fit while it awaits a Fed that seems determined to let the inflation dogs run for a while before trying to hem them in. However, that doesn’t seem to be today’s problem.

The 5-year part of the curve is the outer boundary for most credit union investment portfolios. But the positive slope as you approach that area makes for tempting investment opportunities.

Jeff Smith
Director of Investment Sales

Jeff's comments and insights, based on his professional expertise and the knowledge he has acquired observing the U.S. economy and global markets, are offered as his own personal observations and opinions, and not necessarily reflective of those held by SunCorp, our board or member credit unions. Please do not respond to this message as this e-mail address is un-monitored.


March 2014

Worries of a third straight disappointing non-farm payroll report did not actualize, and for now the topic of pausing the quantitative easing (QE) taper appears to be off the table. Total non-farm payrolls added on the month were 175 thousand......Read More

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