Bond Blues

January 12, 2017

All eyes are again on the Fed with their upcoming meeting December 13th and 14th.  As of November 30th, the futures market has priced in an interest rate increase with all but certainty.  The last time the Fed raised rates was a year ago now.  Most at that time thought interest rates would then increase several times in 2016.  Obviously that hasn’t happened.

The election had its impact on this certainty.  On the night of the election, the odds of a December rate increase went from about 80% down to 50%.  Just as the stock market bounced back handily the day after the election, so did interest rate futures, returning to their 80% level quite quickly and continuing their ascent to the almost 99% level we are at today.

Why has this been happening?  First and foremost, the bond market has interpreted a Donald Trump presidency could mean both higher inflation expectations as well as economic growth.  This in turn leads to the expectation of higher interest rates.  They also lead to the idea that stocks could benefit from that regime.  The result of these changed expectations can be seen in the chart below:

Source: Morningstar Direct. Data from 11/9/16 through 11/30/16


The clear loser on the right has been bonds.  This is because interest rates, which were at 1.83% on election day (10 Year Treasury bonds) have now risen to 2.42%.  The direction of interest rates and the prices of bonds tend to move in opposite directions.

However, back up a little bit to the beginning of the year.  Again, the market was holding onto the idea interest rates would be rising with the Fed likely to raise rates four times.  The exact opposite happened.  Rates fell.  Subsequently, bond index returns shined, up 5.8% through the first three quarters of the year.  While that was nice, it’s kind of like bonds gave too much too soon to their investors.

Instead, remember at the beginning of the year rates were expected to rise and we could maybe get 2-4% on bonds.  Fast forward 11 months and rates have risen slightly and the bond index is up 2.5%.  In short, a lot of noise has happened to end up almost where things were thought to go in the first place.

The biggest thing to think about now is will the decline we’ve seen since the election in bonds persist?  Are stocks a better place to be over a Trump presidency than bonds?  When we think of a time period of 4 to 8 years, we’d have to say yes.  But that’s not because of politics or policy.  It’s because of the idea that over longer stretches of time, stocks outperform bonds.  We have to remember the role of bonds.  They are not there to chase returns.  They are there to protect against the inevitable downturn in stocks.  We don’t have any idea when that downturn will come.  We just know it will.  And over the next 4 years, there’s a good chance we see a 20% or more drop in stocks.  Why?  Because that’s what stocks do.

One data point surrounding this idea is the US economy has been in recovery mode for about 88 months.  To reach the end of Donald Trump’s first term would mean it goes on another 51 months, or 139 months in total.  If that happens, it would be the longest expansion ever.  While this expansion could certainly be record breaking, bonds are there in case it’s not and that is a vital portfolio role.

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