Revenge of the Bond Nerds
John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
March 21, 2021
Bond Vigilantes at the Gate
A bond vigilante, or bond nerds as we have been termed, is a bond market investor who protests monetary or fiscal policies considered inflationary by selling bonds which decreases bond prices, thus increasing yields. Now, I know in our “woke” environment I am not to refer to any group of people in terms that could be considered derogatory, and I do not want to be accused as being a racist against nerds. But as a University of Chicago graduate with a master’s degree in Quantitative Finance, I am one of these “nerds”. It is a proud term, but right now the bond nerds are acting up. They must be stopped.
From October 1993 to November 1994 during the Clinton administration, bond vigilantes rose US 10-year yields from 5.2% to just over 8.0%. Their concerns were about run-away federal spending, and the episode became known as the “Great Bond Massacre.” After the Republicans took back the House touting their “Contract with America”, the Clinton administration and Congress reduced the deficit, and 10-year yields dropped to approximately 4% by November 1998. The bond vigilantes next showed up during the Eurozone crisis that started in 2009. Bond vigilantes were blamed for pushing up the government borrowing in the PIIGS (Portugal, Italy, Ireland, Greece & Spain) countries. However, the actions of central banks were able to keep rates low against the pressure of bond vigilantes. Finally, during the Obama administration some suggested that bond vigilantes were making a return with worries over sustainability and budgetary responsibility around the whole idea that we needed to spend our way out of our economic problems. Federal Reserve intervention was necessary to stem the tide of increasing rates back then, and the question now is will history repeat itself now in response to the recent interest rate spike in treasury bonds.
The conditions that precede a battle with the bond vigilantes are high deficits coupled with what is viewed by the bond market as excessive spending. Against that backdrop you can understand the recent spike in yields across the intermediate and long end of the yield curve.
Our View of the Rise in Yields
The recent run-up in yields is typical of the early recovery phase of an economic rebound. Typically, these early rises will reverse, but a reversal this time could be the result of bad economic news which we do not see happening.
A more likely interest rate retreat would be caused by the equity market entering the bear market territory. In October 1987, I was working as an analyst for a Wall Street firm and the rise in long-term treasury bonds to 10% collided with a richly valued equity market resulting in a record one-day plunge of 22% on Monday, October 19, 1987 in what became known as “Black Monday”. In 2018, when the 10-year treasury hit 3%, the equity market dropped just shy of a bear market drop of 20%. The Federal Reserve immediately halted and later reversed hiking the Federal Funds Rate. This time the Fed will be jumping in to buy long-term bonds if they believe the rate rise is “disorderly” which means not gradual enough to avoid dislocations in the equity market. If bond vigilantes caused rates to rise too fast, they will be “headed off at the pass” by the white-hatted Fed Chairman Jerome Powell.
The evidence for my assumption here is provided in the minutes of the Federal Open Market Committee (FOMC) report to Congress last week. In those minutes of his testimony Chairman Powell indicated that “we think that our asset purchases, in their current form, are the right approach. We could change them in a number of different dimensions should we deem it appropriate, but for now we think our policy stance is appropriate.” (FOMC minutes -3/18/21). I read that to mean that if the bond vigilantes get out of hand and raise rates that the Fed views as “disorderly”, they will intervene to buy long-term fixed income securities to reduce rates. Again, the Fed has investor’s backs, and we should take some solace in the fact that we have an extraordinarily strong friend backing us up. Equity prices may fall, at times dramatically, but the market will rebound if this comes to pass.
Economic Outlook
We expect an initial surge in inflation from a burst in demand from economic reopening and stimulus checks which will meet supply bottlenecks due to a rusty supply chain made worse by overly conservative demand estimates from once-scorched purchasing managers. This is a temporary condition, at best, and supply will quickly adjust to the robust demand we have seen coming since the Pfizer and Moderna Phase 3 trials produced tremendously positive results.
Armed with these effective vaccines with immunization rates suggesting that we will start reaching levels associated with herd immunity later this year, pent up demand fueled with stimulus checks and new employment, the Fed keeping rates at near zero, and a possible infrastructure spending bill unlocking additional productivity gains down the road results in a forecast for Gross Domestic Product (GDP) growth of 6.5% this year, unemployment dropping to 4.5% by year-end, and inflation rates between 2-2.4% by Christmas.
Corporate cost cutting during the pandemic has left companies with tremendous upside earnings leverage, and personal savings rates fueled by new employment and fiscal stimulus has created positive future spending capacity among consumers.
All things considered, interest rates aside, the economic fundamentals supporting the market are strong.
Bottom Line
If the equity market gets spooked by the reemergence of the bond vigilantes and rapidly rising interest rates, we believe that the weakness in equity prices will be temporary and ultimately backed by positive economic fundamentals and the bond vigilante killers at the Fed.
Portfolio Construction
As we have been writing about, the early phase of economic recovery is a good time for value styled equities, as well as financials, energy, and consumer cyclical companies. We are not abandoning the blue-chip technology stocks we own by any means, but we are adding tactical positions in these economically sensitive sectors to provide an even balance between growth and value-oriented investments.
Catching Up
We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link. In the interim, if you would like to get something on the calendar, please send me a note with some dates and times.
Warm regards,
John