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There has been no shortage of news articles on the risks to bond investors following the election driven selloff in the fourth quarter of last year. Reflation, or the concept of an economic growth driven increase in the level of inflation, has consistently been at the top of the list. And rightly so. Bond investors receive a set level of interest payments over the life of a bond. Inflation has the potential to make those future payments worth less. To compensate for the expectation of, or for actual higher levels of inflation, investors demand higher long-term interest rates. This increasing of interest rates to combat against inflation is what triggers a decline in bond prices like the one we saw in Q4. The key point here is that the market controls long-term interest rates.
The Federal Reserve also watches inflation closely. A stable rate of annual inflation, which the Fed defines as 2%, is one of its two mandates (the other being full employment). When the Fed senses that inflation may be close to or moving towards its target, it usually tightens monetary policy by raising the federal funds rate, which is an overnight lending rate. At the March FOMC meeting, the Fed took this action by raising the FFR 25 basis points to a new range of 0.75 – 1.0%. The key point here is that the Fed only directly controls very short-term rates.
So with all of this talk of inflation and rising rates, why would current market conditions be a sweet spot for bond investors?
First, the economic growth driven fears of inflation are proving difficult to justify, at least so far. First quarter GDP growth is likely to come in around only 1% and inflation, as measured by the Core PCE, has moved up in recent months, but is still running below the Fed’s target of 2%. More importantly to the forward outlook, however, has been the new administration’s struggle to pass legislation. The recent failure of a new healthcare bill highlights the difficult policy environment in Washington and casts doubts on the possibility of major tax reform and infrastructure spending plans being enacted this year. Tax reform and infrastructure spending were two of President Trump’s major campaign pledges. Both have the potential to increase inflation, hence the bond market selloff after his victory last November.
Second, the Fed normalizing the fed funds rate doesn’t have a large effect on short-term bond prices because the duration, or interest rate sensitivity of short-term bonds, is so low. In other words, a 25 basis point increase on a 6-month bond has a minimal impact on that bond’s price. Further, when the bond matures, investors can reinvest the proceeds into new short-term bonds that are now yielding more. In other words, the overall yield and income generation on bond portfolios rises as the Fed raises the FFR, even if long-term rates don’t move.
Here is a snapshot of interest rate movements in the first quarter:
Long-term rates were essentially unchanged and short-term rates rose in-line with the fed funds rate increase.
Even with the increase in short-term rates, bond market performance was positive in Q1 as measured by Bank of America Merrill Lynch Indices:
Positive performance coupled with the opportunity for income generation to rise over time, that is what we call a sweet spot.
Source: Bank of America Merrill Lynch, Bloomberg