Due to continued bond market volatility, we’re providing an update and expansion to our Fixed Income Team’s insights, first published on June 19 (Bond Funds Hit a Rough Patch: Reassurance from Our Fixed Income Team).
Putting Recent Market Moves in Perspective—Seeing Some “Normalization”
Bond investors continue to be spooked by heightened volatility and a spike in interest rates, which started in May (when rates were extremely low) and carried through June (leaving rates at significantly higher but still low levels, from a historical perspective).
During that time, the 10-year U.S. Treasury note yield rose almost 1% (from 1.63% on May 1 to 2.61% on June 25). That’s a big increase in a short time, the biggest, in absolute terms, in a short time since the 10-year Treasury yield rose more than 1% (from 2.39% to 3.47%) from October 8 to December 14, 2010.
But this latest big move, from a broader perspective, is basically just the start of a “normalization” of rate levels. To put recent rate levels into proper perspective, the 10-year Treasury yield was around 3.0% two years ago (June 2011), before the U.S. Federal Reserve (the Fed) expanded its quantitative easing (QE) program. Even during the Financial Crisis, at the end of 2008, the 10-year Treasury yield never dropped below 2.0%. So we’re coming off extreme, artificially low, largely QE-influenced levels.
We believe it’s worth emphasizing that much of the bond market’s interest rate declines (and price gains) since the 10-year Treasury yield last spiked in 2010-11 have been technical in nature as opposed to fundamental, as yields were driven down in part by the Fed’s extensive bond buying through QE. So, it shouldn’t be surprising that this May/June bond selloff has been largely a technical reversal of some of that downward rate move since 2011, fueled by a growing belief that the Fed will begin to scale back QE later this year.
Economic, Inflation Fundamentals Still Argue for Low Rates
Signs that QE might be reduced (or “tapered”) have been met so far with violent market reactions. (The financial media has recently made frequent allusions to the markets behaving like monetary stimulus addicts going through QE withdrawal symptoms.)
To a certain extent, the violent reactions are understandable. Fundamentally, the U.S. economy is still struggling with high unemployment and debt levels, and inflation is very very low. The economy may very well be reliant on QE for continued growth. In the economic community, and within the Fed itself, there’s no clear consensus about whether the U.S. economy still needs QE, or if it should be weaned from QE.
Bernanke’s Warning Shot
Despite this policy uncertainty, Fed Chairman Ben Bernanke plunged ahead. He chose to fire a warning shot across the capital markets’ collective bow after the June meeting of the Fed’s interest rate policy committee, triggering much of the recent market volatility.
On one hand, Bernanke said the U.S. economy remains hampered by high unemployment, government spending cuts, and higher tax rates. He added that tightening monetary policy too much now would endanger the economic recovery. But he also said that as the employment outlook improves, the Fed could reduce QE in coming months. Red alert. Alarm bells. This was not what the markets wanted to hear. It started a massive selloff in Treasuries and most other U.S. fixed income sectors.
And it wasn’t just the bond market that suffered. Recent stock market returns have also been driven by low interest rates and the perception that the Fed is “all in” in terms of supporting the economy. So any signs that the Fed might be reducing its bond-buying/economic stimulus have been met with concern by both bond and stock investors, with strong reactions across both asset classes.
Not “The Big One,” but Still Preparing for Eventual Higher Rates
Fundamentally, we do not view this recent rate rise as “The Big One” (such as we experienced in 1994), nor do we think that “The Big One” is coming this year. We believe Bernanke merely fired a warning shot about QE—including introducing the notion that the Fed could vary QE levels in coming months depending on economic conditions—and the markets reacted in a rather extreme fashion. We expect this kind of volatility to continue as the Fed attempts to further define and refine its monetary tightening policies and messages.
Given the largely technical (not fundamental) nature of the recent bond market volatility, and our strong conviction that we’re still in subpar economic recovery conditions with very low inflation, we have maintained the duration (a measure of bond price sensitivity to interest rate changes) of our bond portfolios at neutral levels relative to their respective benchmarks. But, knowing that even higher rates are likely ahead in the long run, we have made other defensive moves.
For further discussion of our bond portfolio positioning and thinking, please see our June 19 blog post:
Bond Funds Hit a Rough Patch: Reassurance from Our Fixed Income Team.
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Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of our Fixed Income Team and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.