As an investing community we tend to focus mostly on stocks and the stock market. Apple this. Amazon that. Where did the Dow Jones close today? But currently, what may be more interesting is the bond market. The bond market and its corresponding interest rates have much to say about what is going on in the economy and what we could be headed for.

Let’s start with the basics. The US bond market is made up of debt issued by corporations, governments (federal and local), and government agencies. As of the end of last year, the total outstanding bond market debt in the US was just over $40 trillion*. Compare this to the market capitalization of the Russell 3000 – which covers 98.5% of the country’s market capitalization – at about $30 trillion^. As with stocks, bond prices/yields are set by the market through supply and demand. However, there are many components that go into the two sides of that equation. That’s what makes it somewhat complicated.

Currently, the benchmark ten year US Treasury Note is yielding 2.96% (as of 4.20.2018). This is 0.56% higher than it was at the end of last year. In interest rate terms, that’s quite a change. There are many reasons for the increase, including the anticipation of higher GDP and wage inflation. Both of these factors should be good for the economy and cause investors to demand higher rates for longer term Treasuries. On the supply side, the Federal Reserve began to unwind its quantitative easing (QE) program late last year. In doing so, they are not reinvesting tens of billions of dollars worth of bonds as they mature, thus increasing supply. This should also increase rates.

There are also forces which appear to be pushing the other way. The last subtle dip in rates came with the talk of tariffs. Tariffs would most likely constrict some areas of the economy and cause a slowdown in growth. A more pressing force is the global interest rate environment. Rates around the developed world are significantly low as central banks conduct their own QE programs (buying their own bonds). As of 4.20.2018, the ten year Government bonds of Japan, Germany and France were yielding 0.06%, 0.59%, and 0.80%, respectively***. Global investors looking for Government bonds will likely gravitate to the US market and bid our bonds up. (remember for bonds, higher prices = lower yields)

Interestingly, as the Federal Reserve has been raising the (short term) fed funds rate, longer rates have only just started to increase. And, in many estimations, they haven’t risen high enough. In that vein, something important to watch is the yield curve. This is the difference between the rates on the short end and the rates on the long end. The longer yields should be higher than the shorter ones, largely due to inflation. If inflation is a proxy for growth, then a healthy, growing economy will have an upwardly sloping yield curve. A quick way to look at this is to chart the difference between the ten year Treasury yield and the two year Treasury yield. One year ago (4.19.2017), the spread was 1.02**. As of 4.19.2018, it was 0.48**. If the spread goes negative (i.e. the short term rates are higher than the long term rates) this is called an inverted yield curve.

There are several implications of where rates are right now. Stock market-wise, higher interest rates may cause investors to re-evaluate where they think stocks should trade. A very common way to value stocks is by discounting cash flows. Basically, that is comparing a company’s earnings to a base, risk-free rate (usually Treasuries). All things being equal, if the risk-free rate increases, an investor may be willing to pay less for a stock. Think of this way, if you can earn 1% without any risk, you’d probably pay extra for an investment earning 5%. If you could now earn 3% without any risk, you’d probably be willing to pay less for that same investment earning 5%. (please note this is just an illustration and not an actual investment)

Economy-wise, we could be in a precarious spot. Since 1980, every time the yield curve inverted, the economy went into a recession shortly thereafter^^. And, with the current spread at 0.48, we are getting close. There are a few theories behind this. One is that the Fed sometimes over-tightens using monetary policy and constricts the economy too much. And yes, we are currently in a tightening phase.

The bond market is definitely trying to tell us something. Unfortunately, with so many inputs it is difficult to say what the output (i.e. rates) means. Growth does not seem to be as robust as many had hoped. But inflation seems to finally be creeping back into the economy. X-factors that cloud the picture even more are the weakness of the US Dollar and fiscal policy that has embraced deficit spending. As with most things in the economy, there is no “a+b=c”. Higher long term rates would probably be a good thing. As long as they’re not too high. And keep an eye on the bond market. It’s talking to us.

 

Gavin Chinn

Investment Advisor

CUSO Financial Services, L.P.

at Verity Credit Union

 

 

 

 

 

 

*https://www.sifma.org/resources/research/us-bond-market-issuance-and-outstanding/

^https://www.nasdaq.com/article/the-us-stock-market-is-now-worth-30-trillion-cm906996

**https://fred.stlouisfed.org/series/T10Y2Y

***https://www.bloomberg.com/markets/rates-bonds

^^https://www.thebalance.com/inverted-yield-curve-3305856

 

 

Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. Verity Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.

Gavin Chinn

Check the background of this investment professional on FINRA’s BrokerCheck.

An Investment Advisor registered through CUSO Financial Services, L.P., Gavin has 22 years of experience as an advisor in the Puget Sound area.

“I believe every client is unique and deserving of a personalized financial plan that will help them reach their individual financial goals. Before I make any recommendations, I like to get to know my clients. By asking the right questions, and developing an honest, trusting relationship I can really get a sense of what’s going to work best for them.”

Gavin graduated from the University of Washington with a BA in Business Administration and started his financial career with US Bank in the Investment Department. Prior to joining Verity in 2006, he spent eight years with Piper Jaffray.

So what is Gavin’s vision for his dream retirement?

“My dream retirement would be absolutely worry free: financially, emotionally, and in every aspect of life. My finances would be in order so expenses for travel, luxuries, and gifts for the kids, grandkids, and great-grandkids would be taken care of. My kids would be financially sound, so I would be confident in their prosperity. This would give me the freedom to travel and play and do whatever it is I want to do.”

When Gavin’s not working, he enjoys spending time with friends and family, watching Husky football, and taking weekend trips around the Northwest.

Gavin is registered to transact securities business in the states of WA, OR, CA, AZ, FL, HI, ID, IL, MN, NM, NY and VA.

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