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Posted on JUN 13, 2017

Johnson Bank Wealth Weekly Investment Commentary | Tuesday, June 13

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.

Summer Vacation

As the temperature rises to near 90, hotter than usual here in southeastern Wisconsin, we know that summer is here. While the summer solstice is still eight days away, most count Memorial Day weekend as the official start of summer break. A lot of pundits will put out their list of books to read while on summer vacation. However, because the investment markets remain open and the economy will continue to hum along, I thought we'd try something different and prepare a list of things to pay attention to over the summer. This may provide clues as to how your bond investments will fare in the months to come.

Central Bankers

I know, you're thinking, “Do we still have to hang on their every word?” The short answer is yes, because our own Federal Reserve Bank (Fed), the European Central Bank (ECB), Bank of Japan (BoJ) and Peoples Bank of China (PBoC) have used unusual monetary policy measures to stimulate growth in their own economic regions. This has included, in some cases, pushing interest rates below zero and purchasing securities in the open market. The collective demand for securities has raised bond prices beyond what central bankers' normal activities would otherwise produce.

Now, these bankers are going to try to explain to investors how they will go forward from here. In the case of the Fed, it has hiked the Fed Funds rate three times since December of 2015—most recently in March of 2017. This week, it will have an opportunity to do so again because the Federal Open Market Committee meets Tuesday and Wednesday. On June 14, the Fed is expected to discuss the hike in the Fed Funds rate as well as provide additional clarity on how to shrink the Fed's balance sheet. This latter point will be important to watch. The Fed wants to be sure bond investors understand the plan before it is executed. Hopefully, this week the Fed will provide more detail on how to exit its multi‐trillion dollar position in Treasuries and mortgage‐backed securities.

In addition to watching Chair Yellen's speech on Wednesday, we'll be watching the 2‐year Treasury yield as well as the difference in yield between the 10‐year and the 2‐year Treasury this summer. The 2‐year Treasury is a good proxy for how the market feels about future hikes in the Fed Funds rate. Prior to the election last year, the 2‐year yield was near 0.8%. Subsequently, the yield rose to over 1.25%, accurately predicting the December and March hike in the Fed Funds rate. Today it stands at 1.36%, near the highest yield of 1.4%, suggesting another hike is near.

We also monitor the yield difference between the 2‐ and 10‐year Treasuries. While the shorter maturity interest rate reflects the future for the Fed funds rate, the intermediate interest rate (that of the 10‐year) reflects bond investors' view of the future for inflation and the premium demanded for tying up money for 10 years. As you can see in the chart below, this rate has been getting smaller since peaking in 2010 at 2.84%. Today it stands below 1%. We monitor this spread because it has the ability to tell us how intermediate‐term investors are feeling about the future of inflation. When they believe inflation will be low, they demand a smaller premium for lending money over 10 years. If inflation expectations rise, they bid up the yield of the 10‐year in an effort to get compensated for those higher expectations.

A 10 year trend showing the treasury yield, minus the two year treasury yield.

While there are some concerns about the economy slowing down, most believe we'll end up with 2% real growth again this year. In other words, there is not much pushing inflation higher. Watching this spread may also help to forecast an economic slowdown. If the yield difference between a 10‐ and 2‐year Treasury reaches zero—or worse, negative—it would suggest that investors believe the Fed's policies are disconnected from reality. This happens when Fed policy is behind the economy. As you can see from the chart, the spread has shrunk by 0.5% since the beginning of the year, which is quite a change. We'll continue to monitor this yield difference in order to determine how close the Fed's policies are to intermediate bond investors' policies.

Last week, the European Central Bank made comments about its own policies, noting that it would continue purchasing 60 billion euro per month and maintain a deposit rate at ‐0.4%. Most importantly, the ECB changed its statement. What once read “...remain at their present or lower levels for an extended period of time,” now reads “...remain at their present levels for an extended period of time.” This change suggests that new measures to lower interest rates further will not be taken. It also means that the ECB believes the uptick in inflation isn't enough to warrant eliminating its policies. The ECB's statement and, in particular, its decision to remove the “lower levels” language suggest a belief that it is reaching the end of its stimulus plan. However, when the ECB raises rates for the first time or reduces/eliminates bond purchases, it will do so months or years after the Fed. Because the ECB provides a significant amount of liquidity in European markets, any change in policy needs to be monitored closely. The ECB's next meeting is July 20, which will be one to watch for updates in strategy.

While you're enjoying some time off, take some time to look at bond market yields and what they are telling us about the future for economic growth and inflation. Enjoy.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE


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