Posted on MAY 22, 2017
Johnson Bank Wealth Weekly Investment Commentary | Monday, May 22
This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.
Returning to Normal
According to Google, “normal” can either be defined as a city in the state of Illinois or a word that describes a condition as typical, average or usual. Today's political environment seems a little less usual. The Trump administration seems to be having a hard time staying on point with regard to health care and tax reform. However, bond investors, unlike the administration, seem to be returning to a more typical state.
Trying to Help
We have experienced almost a decade of unprecedented central bank intervention in bond markets. Ever since the 2008‐2009 financial crisis, central bankers in the U.S., Europe and Japan have taken it upon themselves to provide an unusual amount of stimulus to prime the global economic pump. Even the central bank in China has gotten in on the act in the last several years as it manages the transition from an export to consumption‐driven economy.
The approach to this stimulus came in two forms. The first, very low interest rates, began when the Fed reduced the federal funds rate to near 0% in 2009. As you can see from this chart of the Effective Federal Funds Rate, once there, it remained until December of 2015 when the Fed raised the rate by .25%. Since then, it has raised it twice more.
These low interest rates were promulgated in order to make borrowing money inexpensive. The hope was that cheap money would stir demand for capital which would result in business investment and consumption. When this didn't work, the Fed began its first of several quantitative easing programs. These programs allowed the Fed to increase the amount of its purchases of Treasury and mortgage‐backed bonds. The dollars used to make these purchases went into the financial system. The hope was that this additional liquidity would make its way into the economy and create investment and consumption. While it is difficult to say that the program had the Fed's intended consequence, it is easy to point out that the flood of liquidity most likely improved asset prices. As rates declined and the Fed purchased Treasury bonds, it led to higher bond prices in all sectors of the bond market, including corporate and municipal bonds. Lower yields and higher prices likely drove some money from the bond market to other assets such as stocks, in particular, those that pay a higher dividend, as investors sought alternative sources of income. This bond purchase program ended more than a year ago.
The fact that the Fed has begun to raise rates and ended its bond purchase program is an acknowledgement that the economy is returning to “normal” and no longer requires special efforts to generate greater economic growth. This does not mean that growth is normal; rather it means the Federal Open Market Committee (the group responsible for setting rates) believes that it is no longer necessary to take extraordinary measures.
When we remove the interventionist policies of the central bank from the bond market, it too should return to normal. In normal times, the key drivers of the bond market include the supply and demand for the government's Treasury debt, the rate of economic growth and its effect on the rate of inflation. In this way, the fiscal policy steps taken by the administration and Congress will influence interest rates.
Think back to the November election. In one week, the yield on a 10‐year Treasury rose from 1.88% the day of the election to almost 2.25% the following Tuesday. Within a month, its yield was above 2.6%. The election marked the official hand‐off from central bankers' monetary policies to the federal government's fiscal policies.
Rates moved higher because the then president‐elect had made it clear that he was interested in spending money on infrastructure and reducing corporate and individual taxes. Both of these have a cost that would likely increase the government's deficit, which in turn raises the supply of Treasury debt. If demand remained equal, then interest rates would have to rise, and they did. The market's anticipation of tax reform also led investors to conclude that economic growth could pick up along with inflation. This, too, led to higher interest rates.
In other words, bond investors immediately discounted the new administration's plan because not only did Trump win, Congress was also in the Republicans' control.
What's happened to bond yields now that things look more normal? After the initial discounting that raised bond yields almost 1%, investors caught a glimpse of just how difficult it will be to change fiscal policies. With the pace of reform appearing to be slower than originally thought, bond yields have retraced some of their rise. The 10‐year Treasury now sits closer to 2.2% — 0.4% lower than where it was in January.
What's exciting about this? It is normal. Bond investors have returned to an environment where they take in information about the supply and demand for bonds, pace of economic growth and inflation, the policies affecting monetary and fiscal policy and then price securities accordingly. We should take comfort in this progress and the fact that the market is indicating the return to normal will take some time, meaning interest rates may rise gradually at a pace that is helpful not harmful to investors.
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.