February 2022
With three teenagers at home, we have one appliance that is always running – the washing machine. It seems it has been running for years on end. When our kids were little, it cleaned food stains from countless tiny clothes. Now, it battles the teenage funk saturating piles of laundry on the floor. Despite its dutiful performance, I rarely find myself thinking about this particular appliance. It just hums along in the background of our home all day (and most of the night), but when the washing machine starts making a funny noise, we have a problem. A funny noise can lead to a broken washer, which can cripple household operations.
An Important Apparatus
The bond market can be quite similar. Despite its critical importance to financial markets, it is rarely discussed by the financial media, and much like the washer, that discussion only occurs in a frantic tone when it starts acting oddly or stops working completely. As a former bond fund manager, I can regretfully inform you that most financial advisers either 1) do not understand the bond market; and/or 2) do not pay much attention to it. When asked about a stock, many can talk about a P/E ratio, dividend yield, or book value per share. Ask the same folks about the convexity or spread duration of a bond and they look at you like you have two heads.
Why are the fixed income markets uninteresting to so many? The global bond market is larger than the global equity market ($124 trillion vs $106 trillion per SIFMA.org). Bonds generally have more certainty embedded in them than stocks and tend to be a bit “mathier” investments with more objectively “right” and “wrong” investment decisions revealed in the post-mortem – a bond either pays out coupons and principal at maturity or it does not. Perhaps folks think bonds are less exciting because the potential rewards are more muted? I have yet to hear someone (excluding another bond manager) brag about a bond’s return. Whatever the case for this fixed income apathy, the washing machine that is the bond market is starting to make a funny noise and we have noticed.
Yields on a two-year Treasury bond have increased from 0.5% three months ago to 1.5% today. That is a giant move in a short period of time. By way of comparison, the two-year Treasury yield essentially traded between 0% to 1% during the eight years spanning 2009 to 2017. Why such a big move now? The Federal Reserve, as has long been anticipated, began communicating to the market that more restrictive monetary policy is on the way. Further, inflation data has been running hotter than market expectations, which is saying something since expectations were for quite high inflation over the next several years. As a result, the Fed has messaged that they must act forcefully. Three months ago, the market expected two interest rate hikes (each being 0.25%) by the end of 2022. Contrast that with today, where the market expects six rate hikes by year-end.
Rising interest rates often present all sorts of challenges to the market, particularly when rates are rising quickly. Borrowing costs for companies and individuals increase, bonds become more attractive investment alternatives, and currencies can fluctuate. All of these effects can contribute to greater volatility in the financial markets. To further complicate matters, higher volatility often perpetuates even higher volatility, as investors shed risky assets like stocks and park their money in cash as they ride out the storm. We have witnessed all these phenomena over the past quarter, and if you have peeked at your holdings recently, you may have noticed the same.
Flashier Than Washing Machine Repair
Russia’s impending and subsequent invasion of Ukraine has dominated headlines for the past few weeks. Financial pundits will have you believe that this is what ails the market. Building off our prior analogy, this is akin to blaming the laundry pile-up on a lack of laundry baskets; however, those who do the laundry regularly hear the noises from the machine and know something is amiss. One may ask, why would the talking heads be emphasizing this narrative? I posit that war, tanks, and Vladimir Putin are all more interesting and easier to comprehend for the investing public than yield curves, quantitative tightening, and Jerome Powell. Certainly, geopolitical conflict always poses a risk of becoming widespread and evolving into a crushing blow to global growth. This episode in Ukraine likely carries more risk on that front than most conflicts we have witnessed over the past several years, but we doubt this turns into global warfare.
When it comes to what has really been hampering this market in recent days (and likely the days ahead) we feel confident that the real agitator is the market’s uncertainty of the long-term economic impact from a monumental switch in Fed policy from historically stimulative to somewhat restrictive. Will the Fed over-tighten and cause a recession? Will the Fed under-tighten and the U.S. economy be hampered by persistently high inflation? Will wages spiral out of control as the U.S. economy comes back online? Will supply chain issues be resolved, or will global conflict add to that challenge? The bond market is trying to predict the answer to all of these questions, and as a result, the machine is clanking around a bit.
A Transition Back to Normal
As you likely know, we prepare investment plans and allocation targets to withstand these periods of uncertainty and volatility. By skewing towards quality throughout the portfolio, we try to make sure that our investments can weather whatever comes their way and are still in a good position to benefit whenever the recovery may occur. While unfortunate in the short-term, we view this volatility as a healthy development as the U.S. begins to transition to a more “normal” monetary policy. The “abnormal” phase was the post-pandemic market: a period of unprecedented stimulus from the Federal Reserve and the U.S. government resulting in limited downside risk as markets surged higher. While it is nice to see rising account balances, such periods tend to lead to excessive risk-taking, like your neighbor doubling their money in a week by investing in a crypto-based SPAC. (If you do not know what a SPAC is, you are probably better off for having missed that market fad.)
Despite the recent turmoil and “clanking” we hear in the bond market, we forecast that corporations, particularly in the U.S., continue to have a healthy backdrop for growth over at least the next one to two years. Consequently, we do not believe the washing machine is broken badly or in need of a total replacement. We hope a relatively painless visit from the repairman (read Jerome Powell), who hopefully has the “tools” and “parts” he needs, will calm the household and get the machine running smoothly again.