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What's Going on in the Markets: A Bond's Eye View
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What's Going on in the Markets: A Bond's Eye View
On October 3 U.S. Federal Reserve (Fed) Chairman Jerome Powell’s comments indicated for the first time that they may tighten their monetary policy. Equity markets have traded lower every day since that statement. It is important to note that U.S. Treasury yields moved first, followed by equity/risky assets. I’ll explain why this is important, but first let’s discuss what is going on in the markets.
An important distinction
The Fed has been raising rates since December 2015 to remove excess accommodation. The goal has been to “normalize” policy rate levels to neutral. Moving to neutral IS NOT the same as tightening. Powell on October 3 announced he may tighten the Fed’s monetary policy, and this set in motion the events of higher rates and falling risky asset prices.
Based on Fed models, a 3.00% fed funds rate is widely viewed as the neutral rate (real fed funds rate (r*) of approximately 1% + 2% inflation target = 3%). This is approximately what the market is pricing for the terminal fed funds rate.
What changed?
Powell’s comments indicated that the Fed may increase rates toward 3.50%, reinforcing the Fed’s “dot plot” prescription, which is 50 basis points higher than the 3.00% market consensus policy rate—meaning a tightening of 50 basis points for which asset prices need to reconcile.
Assessing the risks
Much of the adjustment in asset prices has come not from U.S. Treasuries but from riskier assets, namely equities that are adjusting to a higher discount rate (interest rate) for cashflows (earnings).
Mathematically, this has mechanical consequences, some of which are:
- It lowers the present value (PV) of prices (equity prices fall).
- Bond spreads widen in response to an upward change in the risk-free rate. This happens because spread product is typically short the credit default option, a component of the spread, which increases in value (rho, in option terms). In other words, you become short a more expensive option, thus the spread widens to reflect this option price change.
A rise in risk-free rate sets in motion this mechanical repricing of risky asset valuations.
Bottom line
Market price action today can be explained mathematically through the mechanics set in motion by a rise in risk-free rate expectations. Of course, this could trigger knock-on effects and an overshoot under the mechanical fair value—perhaps this is what we are seeing today. We are not diminishing this risk, but we see it as a temporary correction. Why? Because economic fundamentals remain strong, which to us are more important for medium- and long-term investment horizons.
An important observation to make is that U.S. Treasury yields barely moved as risky asset prices fell. It is the classic case of the U.S. Treasury market adjusting first, to be followed several days later by riskier assets. This is the cornerstone of our thesis behind this move in risky asset prices, which is that it is a rational and mechanical adjustment to higher risk free rate expectations.
RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities ("junk bonds") are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
