Some on Wall Street say the Bond Market is the smartest due to the fact that participants are only focused on repayment risk and time of that repayment. Compared to the Equity (Stocks) market were there are flows of capital, tons of complication with financials and mood swings by participants.
Given the Bond Markets high IQ status, when it speaks people listen….
Inverted Yield Curve as Bond Market Beats it Chest with a Warning
As a quick refresher, a normal yield curve will have lower rates for shorter terms and higher rates for longer…. simply because the longer the term the greater chance of a problem/stress/default …
Pardon my free hand, but it looks like this… the longer the time the greater the cost/interest rate
When the Bond Market turns upside down/inverts, it has a very good track record of predicting a R- Word!
Note on this long term chart, as the line drops below zero, the Bond Market is Beating its chest and inverting…. also note the grey area that follow are R-Words…
Using a shorter term chart, last week marked a strong inversion of about -.25% and closed the week off at -.20% note those are point 25% and point 20%…. far right below the line…
So it looks like the R Word is in the cards, not to worry we have been talking slowdown since December of 2021… so we are prepared….
Remember, Equity Markets are forward looking and will sniff out the recovery before it is seen…. Also, recall, headlines are the worst near the end…. Still a Ways to Go though!
Next up — Why the Fed is in a pickle and may only have an R- Word way out!
With multiple comments over the last few weeks and a pick up in headlines concerning interest rates, we decided to do an analysis and review! We also have added a video to help explain some of the complexities associated with rates and bonds … as while at face value bonds are a simple animal, their movements can be puzzling.
The main reason for the increased headlines and comments are when rates go up, the value of bonds goes down initially, and rates have really jumped dramatically for various reasons.
Briefly as a reminder, Bond aka Fixed Income aka corporates aka treasuries aka high yield aka Fixed Income instruments are nothing more than a note with an income stream to the purchaser of the bond! There is a saying the bond market is “Smart” because you only have to worry about the ability and willingness of the lender to pay… nothing else…
Rates and Bonds – I Go Up, You Go Down
The Green line is the yield on the 10 year treasury… The red is a huge bond fund from Vanguard called the BND….
No doubt that this is an almost perfect inverse relationship.
One detail worth mentioning, longer term bonds are more volatile, both up and down than shorter term i.e. A one year bond will not move near as much as a 30 year. This makes sense because the longer the term, the more payments that are owed and the more change in the prevailing rate effects the bond.
Fast Fast Fast Movement
In true, be careful what you ask for fashion, (we have long been positive towards higher interest rates) rates have moved incredibly fast, especially Mortgage Back Securities which are pools of mortgages used for determining current new rates…
This is the average 30 year fixed rate mortgage…. as of yesterday, this rate was well over 5%…this rate is almost double the rate just a few quarters ago…. With eventual supply, our home asset is facing some headwinds !
Much of this rate movement is coming from Federal Reserve Bank Presidents public comments…..
Why would they do this? To slow the economy… if they can get the market to move rates up, their job is easier ….heck if they can get market participants to do all the work, the Fed would hardly need to do anything… plus markets are much faster to react than the FOMC (Federal Open Market Committee)
Once interest rates move, a new bigger income stream is the net effect… New purchases or re-investments are met with bigger income payments…
This continued higher income payment begins paying back the headwind of the drop in value as shown in the first chart…
Clipping that coupon will be nicer as rates increase!
How Far Can they Go? Rates and the FOMC?
Here comes is the sizzle…. be careful on extrapolating higher rates into the future… this extrapolation has garnered a lot of headlines as of late …. Whoaaaa
This is about a 35 year chart… go back farther, to a much younger demographic, there was a time when the FOMC raised interest rates to the roof… think 15-18% to tamp out inflation….
With an economy today of much more debt to service and older (more savers, less spender) demographics the last four decades have been a slow but continued lower longer term rate….
Note the top of the prior interest rate cycle looks like the top of the FOMC rate hike…again the last four decades….
With the afore mentioned cycle high repeating as the following cap on rates, looks like, although very fast rate movement recently, the majority of the move is likely over….and therefore less headwind for the value of bonds and bigger coupons….
Lastly… a slowdown in economic times or a rush for the safety of our simple friends usually leads to a reversal in rates and a repeat of the afore mentioned process…but in reverse… lower rates, higher prices!
Have a Great “Bonds and Interest Rate Analysis” Day!
In the middle of this week as noted here on the FOMC Calendar the FOMC chaired by Jerome Powell will most likely increase the short term federal funds rate by 25 basis points or .25%. … think your checking account interest rate.
CME Estimator at almost 100% .25-.50% increase
While the last FOMC meeting was approximately 2 months ago, what may seem like a decade given the events that have unfolded in the last 60 days, Powell in several speeches recently walked back the original 50 basis points or .50% thinking that many market participants had priced in.
Last week’s continued hot CPI report, has bond market participants pushing the probability up of further rate increases, and maybe even a higher 50 basis point rate increase this week that even the Fed has said cryptically would not occur.
As can be seen by this expanded detailed graph of the FOMC federal funds rate versus the two year treasury, the treasury market has rate increases priced in very far ahead of the FOMC.
Should the Federal Reserve increase by 50 basis points, with market participants for the most part not expecting that, turbulence would likely be the result.
This meeting is also accompanied by the economic forecasts also known as the dot plots of the Federal Reserve members, which are their expectations of future interest rates. Keep in mind these estimates fluctuate dramatically, but make for good information.
Look for more detailed information from us on the possibility of why the CPI has already neared the highest end of its range and will continue to roll over as we get copyright approval from a great new source to help explain what’s going on with that report. No doubt we are all feeling inflation costs especially at the food and the gas lines, but due to comparables the other nonparticipating inflationary pressures will likely over power the few extreme outliers.
The third post of a neat (well we think so) new idea, series we discuss “Protection Planning” !
This series is a review of the basics, and will serve as somewhat of a semester study of the Financial Planning foundations all the way to more advanced topics later in the series…. We plan on a mid month release of each part and somewhere south of double digit parts…. possibly with a video added to each for additional insights…. thanks in advance for sharing with those who may find this series helpful….
In this Debt Planning section we cover from a high level …
The Good, the Bad and the Ugly Forms of Debt
Yes there are some debts that or ok, but there are also some that are very much sinners….
Review that Social Security Statement
In this annual reminder post, receiving a weekend email alert directly form the Social Security Administration our review was set in motion and a new post was born….
Happily as mentioned in the post, the SSA had updated the site and there are really neat new features such as a graph for delayed benefits and a neat spousal calculator.. Well done guys!
Please be sure to take 5 minutes and review that your hard earned earnings are being credited to your Social Security Benefit/Number!
Capital Market Comments
Interest Rates Jump Ahead of Fed – Short Term Pressure on Bonds Long Term Gain
While this post concerning how the bond markets, more specifically the two year and ten year treasuries front run the FOMC (Federal Open Market Committee) we also want to remind that such movement, especially seen in the two year treasury puts pressure (lowers) on the value of the bond but also ups the income from the bond……
So initial headwind, and eventual tail wind…yay
Re-Review “The Anatomy of a Slowdown/Recession” the Snap Back
With market jitters creating headlines and lower values, in this post we reviewed our luckily timed lead article in our Q 1 2022 Newsletter article, called the “Anatomy of a Slowdown”
The main purpose of the article and the re-run is to remind everyone INCLUDING OURSELVES, slowdowns (markets dropping in value) do occur, and while we don’t want them to, they do anyway!
In this post, we review three very large what we coined snap backs…. large rallies of 5%-to over 10% which are for some reason very confusing during slow down times and also tend to totally ignore headlines…
No idea for sure WHY they happen, just know they do … thought worth reminding as some great questions came in on the subject.
Have a Great Day, Talk to You at the End of March! Going fast this year!!!
FOMC (Federal Open Market Committee) members use the very short term Federal Funds Rate (think interest on your checking account) to help throttle the economy. When it is too hot they raise rates. In Paul Volcker’s case to almost 20% way back in the hyper inflation days. When the Economy is struggling they lower rates, as of late to zero, both post Great Financial Recession and the most recent Virus induced mini-recession.
There is an interesting predictor or front runner of the FOMC interest rate movement, sparred by the very short term fixed income traders, specifically the 2 year Treasury bond.
Markets Pre-Empt FOMC Rates
The chart below is of the Two Year Treasury (Red Line) and the afore mentioned FOMC Fed Funds Discount rate (Blue Line) –
The correlation is so strong it is almost hard to even see there are two lines….
Zooming into a shorter time frame of just 5 years, not only can we see the difference, but in looking over to the right, the markets are predicting multiple rate hikes in short order, at this time!
Will see if this holds, but as mentioned in our post earlier this week here, Economic number and the markets are expecting rate hikes!
Why this is important? Bond Markets are signaling a much faster interest rate increase(s) than Fed Speak… Someone is going to lose this game of chicken… Only time will tell us who?
Frequently, Wall Streeters (my nick name) are quoted as saying the smartest guys in the room are the Bond Markets/Participants.
Some of this rhetoric comes from the simplicity of a bond. Basically you have a time to payback (term) and risk of the asset (Quality i.e. Aa to junk).
With less to focus on, bonds and their players/participants are thought to have greater clarity…. However, in recent years (working on a decade now) the FOMC (Federal Open Market Committee) led by Jerome Powell currently, have been making direct purchases of bonds, causing possible distortions and lack of true free market discovery….
Recent Two Year Treasury Yields Rise Dramatically
Throwing water on the theme that the FOMC has taken TOTAL control of the bond market, this recent move in the 2 year treasury is signally to the FOMC by bond folks, they expect (and want) rate hikes sooner rather than later….. Hmmmmm
CME (Chicago Mercantile Exchange) FOMC Watch Tool
This neat CME Fed Watch Tool … overlays the current interest rates with a graph to show an expected increase time probability…
The way to read this chart is the orange represents the chance of a FOMC rate increase… March of 22 showing about a 20% chance of a FOMC rate increase….
Push forward to June 22, just two months later, and the probability of at least a .25% increase moves to about 80%!
The thing is, the FOMC is saying maybe one increase very late next year (2022), but certainly not the bond market/participants.
Wait too long and the FOMC may miss their chance to raise … raise too early (not likely at this time) and it could cause an unexpected headwind for the economy.
Let’s grab some popcorn and see who wins this tug of war!
Murphy’s law being applied, the form just arrived last week….about two weeks after our post…..
Reason for receipt:
Rollover of a 401k or the like to an IRA – Most frequent
Contribution to an IRA
Contribution to a SEP
One of the most confusing parts of this form is that even though you may have made a qualified contribution for a prior year i.e. 2020, if you made that contribution in 2021, depending on the type of contribution the Form 5498 MAY show your contribution in year 2021.
Capital Market Comments
Inflation or No Inflation
In this part two post, “The Smartest Guys in the Room” post we discussed via interest rate futures graphs the movement after FOMC dot plot adjustments and the interest rate markets….
This is an updated Graph of the 2 year US Treasury, which is holding lower, (higher yield) possibly due to faster expected rate increases!
This is the ultra long 30 Year Treasury, which continues to trend higher (lower Yield) possible pricing less inflation from the above mentioned expected shorter term rate increases!
Ok…that’s a wrap for the June review…. Hello July!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, please consult your financial advisor prior to investing!
The is the vocal portion of J.K. Financial, Inc. a Dallas Texas Based Fee Only Total Wealth Financial Planning Firm. Founded by John Kvale, a Dallas Texas Fee only Financial Planner and Total Wealth Manager.