May 6th, 2014 | By Nick Sargen
Following a bond rally and stock market sell-off in January, U.S. financial markets have settled into narrow trading ranges in the past three months: The yield on the 10-year Treasury has been centered about 2.7%, while the S&P 500 Index has fluctuated around its level at the beginning of this year. The initial moves reflected investor concerns about a U.S. slowdown, as well as political and economic developments in several emerging economies. More recently, investors have shrugged off weaker-than-expected U.S. GDP growth in the first quarter, fears of an economic slowdown in China and other emerging economies, and heightened tensions over Ukraine. These developments suggest financial markets are in a state of equilibrium, which is likely to continue until there is a major market surprise.
One year ago, the main development that jarred the bond market was the announcement by the Federal Reserve that it was contemplating phasing down its bond purchase program. The announcement caught investors off guard, as the economy was off to a sluggish start and 10-year Treasury yields had fallen to 1.6%-1.7%. Just when investors had concluded yields were likely to stay below 2% indefinitely, they surged by about 100 basis points in the next two months, and they closed the year about 3% on the back of stronger-than-expected economic growth.
The situation today has some parallels, with bond yields having reversed their rise in the second half of 2013 as the economy faltered in the first quarter. This time, however, investors are unfazed that the Fed has cut its bond purchase program roughly in half and is set to eliminate it by the fourth quarter. The principal reason is the Fed has succeeded in convincing investors it is not in a hurry to raise short-term interest rates: Inflation remains well below the Fed's 2%+ target while the unemployment and underemployment rates are considered unacceptably high. And even though the unemployment rate fell from 6.7% in March to 6.3% in April, investors do not expect the Fed to alter policy, considering that the labor force participation rate also declined and wage increases are modest.
In these circumstances, we do not foresee an imminent change in the Fed's policy stance leading to a shift in market sentiment. Instead, the key driver of financial markets is likely to be the performance of the U.S. economy in the remainder of this year.
The consensus view at the beginning of this year was the U.S. economy would accelerate in the next two years, and some forecasts called for real GDP growth of 3% for the first time since the Financial Crisis. With the preliminary estimate for the first quarter being virtually flat, economists have been trimming their growth forecasts for this year.
Nonetheless, it's relevant to consider whether 3% growth is attainable for the balance of this year and next. My assessment is that it is feasible for the following reasons:
There are also several caveats to weigh. One is that a pick-up in residential housing is critical for the economy to accelerate, considering the sector has softened in the past two quarters. While the first quarter decline in housing may be partly weather related, new household formation has fallen short of expectations. A second caveat is that stronger U.S. export growth is partly dependent on China and other emerging economies stabilizing. This appears to be the case, as evidenced by an improvement in market conditions in emerging economies. More generally, the softness in the global economy in the first quarter may be payback for stronger-than-expected growth in the second half of 2013.
In this context, the 40 basis point decline in Treasury yields and further narrowing of credit spreads versus Treasuries so far this year make bonds look expensive to us. Our view is that the economy has transitioned from the early stages of recovery to a more solid expansion over the past year, with the 8.7 million increase in unemployed workers during the Great Recession now being reversed. Moreover, monthly nonfarm payrolls have been averaging more than 200,000 workers over the past year, which suggests a cyclical upturn is well underway. That said, we acknowledge structural problems persist with those who have been out of the workforce or working part time for several years.
If this assessment is correct, we would expect bond yields to rise as the expansion continues. This was the pattern in 2013; however, it has stalled recently for the reasons cited earlier. While the recent bond rally may reflect increased concerns about Ukraine, we would expect yields to rise if tensions lessen. Accordingly, we are underweight in duration in our bond portfolios.
The main change we have made is to eliminate our former overweight position in high yield bonds, on grounds that bond yields in the neighborhood of 5% do not compensate investors for interest rate and credit risks. This move is similar to a tactical one we made a year ago at this time. Thus, we are prepared to reinstate positions should yields rise by 50-100 basis points.