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Are Markets Too Complacent?

Stock and bond prices have been relatively stable the last few weeks, but two recent interest rate announcements suggest more volatility could lie ahead.

Markets have mostly been shrugging off warning signs that, under a different set of conditions, might have sent them reeling. These signals include rising inflation, surging deficits, indications of more Fed rate hikes and increased risk of a global trade war.

Interest rates, too, have remained surprisingly tame. The 10-year Treasury rate, which topped 3% in May, has slipped back to 2.9% instead of rising as might be expected. Stocks, too, have been quite stable this month.

I think investors may be too complacent and more volatility—particularly in the bond market—could lie ahead. There are two significant monetary policy announcements in June that form the basis of that view. It gets a little technical, but let me elaborate:

On June 13, the Federal Reserve hiked the fed funds rate and indicated it would raise it two more times this year and at least a couple more next year. While the Fed has been gradually hiking rates for more than two years, the latest announcement indicated more hikes than expected and represented an increase in hawkishness.

The European Central Bank said it would extend its bond-buying program into the fourth quarter and doesn’t plan to hike rates through the middle of next year. This announcement tilted more dovish than anticipated.

I think yields are staying low for a couple of reasons. Lower for longer foreign central bond rates are anchoring U.S. rates, which are still among the highest yielding of developed nations. Plus, investors are skeptical that the Fed will really hike as aggressively as it now indicates since growth will slow before then.

I can see those points, however I’m not convinced the market is accurately pricing in recent higher readings on inflation and economic strength. I think the Fed may actually hike as many times at it now indicates.

As for the forecast of a stronger dollar (which would hold back rates), I don’t think it is a lock. Exploding deficits and rising trade imbalances could weigh on dollar demand, giving rates a push higher.

Bottom line: I think bond market volatility is likely to resume and the benchmark 10-year Treasury rate could rise above 3%. That’s not priced into markets. I recommend investors adding to fixed income portfolios emphasize short-term bonds and money market funds, which aren’t as likely to be impacted by rising rates as long-term bonds.