The Economist recently compared watching the market in 2018 to watching a horror movie. There is the character that walks out into the dark, the floor boards creaking and the swell of haunting music to build the tension. Is it Freddy Krueger or only the wind?
In response to the drama of the market, the so-called “bond vigilantes” have reappeared. I have not heard mention of the bond vigilantes in over a decade, maybe two.
My family sometimes questions my taste in novels, specifically when I started The History of Interest Rates by Sidney Homer. It goes back to 1988-89, when I was first in the business; I moved out of the bull pen where all rookie brokers began and into an office complex. The two brokers sitting on either side of me had been retail bond brokers for over 20 years and we were located close to the institutional bond trading desk and the municipal bond trading area. I was immersed in the bond side of the business, and discovered just how much there was to learn.
I started by reading Eugene Fama’s Municipal Bond Handbook, a two volume set, which tops out at over 1,700 pages. (Fama, you might recall shared the Nobel Prize in Economics in 2013 for showing that only 7% of professional money mangers do well enough to earn their benchmark plus their fees.) When I had gone through training as a rookie I had learned about building bond ladders, a simple concept.
What the Municipal Bond Handbook had to say went far beyond simplicity. Total yield in a bond portfolio has three components: (1) the coupon interest rates paid by the bonds in the portfolio, (2) the reinvestment of the interest payments, and (3) capital appreciation. Capital appreciation was capturing price movements, pricing disparities, and other characteristics of bonds that added to the total value. The value added by each component was roughly 1/3.
Bond ladders capture the interest rate and reinvest the earnings in new bonds. That amounts to 2/3 of the return, but bond ladders capture little if any of the capital appreciation from the last third, which means the investor doesn’t capitalize on 1/3 of their potential earnings. Of the Municipal Bond Handbook about 1,600 of the 1,700 pages were devoted to that last 1/3.
Sitting next to bond brokers, not only did I get to read about capital appreciation, but I also got to experience and learn it firsthand. For me it was the difference between average or mediocre and superior.
I also learned about the “bond vigilantes”. There is no real group of vigilantes; they are simply bond traders – all those people I sat with as a fledgling broker. They focus on finding capital appreciation and understanding economic conditions that will impact bond prices so they can buy low and sell high. They watch economic conditions to find the anomalies that will add value to their portfolios.
Long time stock market players listen to them because the same economic conditions they watch impact the stock market as well.
Something happened last November that stirred the bond vigilantes. The yield curve began to flatten. Normally short-term rates on US Treasury bills run about the same rate as inflation. This is to be expected. Investing money short-term you would expect to stay up with inflation. But there is very little risk, so no real premium to the rate of inflation. Longer-term bonds like 10 to 30 year US Treasuries pay the buyer about 1 ½ to 2 ½ percent more for the additional risk of holding the bonds for a longer period of time with less certainty of what inflation and the economy will do.
The Federal Reserve has considerable sway over short-term interest rates. They set a target “fed funds” rate and will buy and sell short-term bonds to hold that rate. However, the Federal Reserve does not have much control over longer-term rates. Those rates are set by what price market buyers and sellers are willing to pay.
Since the Great Recession, short-term rates on US Treasuries were around 0.25% and 10 year bonds were 2 – 2.5%.
In November the yield curve started to flatten. The Federal Reserve began pushing up short-term rates. Instead of following short-term rates up in lock step, longer-term rates moved up more slowly. Short-term rates today are 1.5% – 1.75% and 10 year bond rates are 2.8% to 3.0%.
For the bond vigilantes a flat yield curve can imply that inflation is picking up because short-term rates are up. In fact, the CPI index has been increasing over the last 12 months. The bond vigilantes see the longer-term rates failing to keeping pace with short-term rates as an indication that the economy will be slowing down later this year or next. When the economy slows down longer-term prices on bonds increase and yields drop.
If the bond vigilantes are correct and the economy is in fact going to slow down later in the next 12 months or so, that will also impact stock prices.
This is what the fuss is about. That is why for the first time in over a decade we are hearing about the bond vigilantes.
They could be right or they could be wrong. The Federal Reserve in this country and central banks around the world are raising short-term interest rates to return to normal levels. Longer-term rates at current levels may simply be a function of instability in the world and money seeking a safe harbor in the US.
In summary, my guess is the economy is not going to slow later this year or next but instability in the world is going to keep foreigners buying our treasuries and holding the rates low. Like the bond vigilantes I have a spreadsheet I have been updating monthly since the late 1980s with the statistics and data pertinent to bond brokers. I have and will continue to monitor it to stay alert should the bond vigilantes be correct about the economy.