Monday, July 8, 2013

Bonds - 1994 Redux?


Last Friday's surprisingly strong jobs report sent the bond market into a tizzy.

Although trading desks were fairly thinly staffed in the holiday-shortened week, it was still startling to see a 22 basis point rise in interest rates in a single day.

The chart above gives a good picture of the rise in interest rates that has been occurring.  The yield on the 10-year Treasury note is now nearly double what it was a year ago.

Still, as blogger Cullen Roche wrote on his blog Pragmatic Capitalism this morning, perhaps we should be viewing bonds from a longer term perspective.

Roche writes that even after the rise in bond yields over the past few weeks, rates remain very low by historic standards.  Here's a chart from the Federal Reserve that is a good illustration of what he means:

Graph of 10-Year Treasury Constant Maturity Rate

http://research.stlouisfed.org/fred2/series/DGS10/

Here's what Roche writes:

That little tiny move in the bottom right hand corner shows how mortgage rates have moved all the way back to, gasp, their 2011 levels when we were routinely seeing bullish articles about how interest rates are so low and should ease the debt burden on debtors.
 
Now, I wouldn’t say that the recent rise in rates will have zero impact on the economy, but do I think it’s going to torpedo the recovery?  No, I think it’s just a case of traders being traders.  They overplayed their hand on the downside and now they’re overreacting on the upside.  What else is new?  And why should anyone make a big fuss about a 1% move in interest rates that takes us all the way back to levels that are barely shy of all-time lows?   This looks like another case of short-term thinking gone wrong….
 
I think that Roche is on to something.
 
Although stronger economic data would appear to give the Fed room to start pulling back some of its activity in the credit markets, it does not seem likely that they are going to start to aggressively hike interest rates any time soon.
 
Some (older) bond investors fear that we are on the brink of another year of bond carnage similar to 1994.  However, Ned Davis Research this morning pointed out that the Fed hiked short term rates by 200 basis points in 1994 in response to rising inflationary pressures.
 
NDR goes on to say:
 
Today's market is nothing like 1994.  Ten-year yields soared 200 bp in 1994, topping 8% at one point. The FOMC surprised the market on February 4, embarking on a 7-step tightening cycle, which took the fed funds target rate from 3.00% to 6.00% in a year.  As a result, the yield curve dramatically flattened.  The unemployment rate was already 6.5% {we are at 7.6% currently} and fell one point, as GDP accelerated from 2.7% to 4.2% annual growth.
 
 In other words, it seems like a good idea to keep today's rate rise in perspective.