Bond Market Outlook (Post Fed)

Bonds have rallied over the past month, and that’s leading some analysts to declare the bond downtrend “over,” but we remain concerned about the negative impacts of a long term bond decline on client accounts and on markets. And, over the past few months I’ve talked to a lot of subscribers who share similar concerns about client’s bond market exposure.

Despite this short term rally, we were recently reminded of the potential consequences of a bond drop on client portfolios by none other than Carl Icahn.

Earlier this summer, Icahn called Blackrock, one of the biggest asset management companies in the world, “an extremely dangerous company” because it is the dominant player in bond market ETFs.

Icahn made that statement because he, and many other people, believe that if we see the bond market decline accelerate, it could turn into a “debacle” as the bond market simply doesn’t have the liquidity to handle massive redemptions what will come as investors dump these (mostly) newly formed corporate and junk bond ETFs.

And, the concern isn’t without precedent.

We know that part of the reason commodities have gotten hammered lately is because of the proliferation of ETFs in gold, silver, copper, oil, natural gas, etc.  Selling of those ETFs by speculative investors, many of whom wouldn’t otherwise be investing in commodities, has contributed to the recent rout.

And, with the Fed rate hike looming (likely) just a month away, this issue is becoming more pressing.

My point is this:  Whether you believe Icahn or not, the simple fact is that more volatility is coming in the bond market and it will effect client portfolios over the coming months.

Over the past month we have not only seen a rally in bonds over the last month, but also some significant flattening of the yield curve – which itself can be an important warning sign for markets.

Below we’ve included an excerpt from the full, paid edition of The Sevens Report that describers 1) What has happened in the bond market over the past month, 2) Why it’s important for client portfolios, and 3) How we can position to protect portfolios against these potential risks.

Why is the Yield Curve Flattening (And Is That a Warning Sign)? (Sevens Report Excerpt)

Since July, the sharp rally in bonds has been accompanied by considerable flattening of the yield curve. Now, before your eyes glaze over, this is important because material moves in the yield curve can be warning signs for stocks and the economy.

Since July 2, two widely followed yield curve spreads have contacted sharply:

First, 10s—2s (the difference between the 10-year Treasury yield and the 2-year Treasury yield) has declined from 1.76% to 1.53%.

Second, 30s—10s (the difference between the 30-year Treasury yield and 10-year Treasury yield) has contracted from 2.55% to 2.25%.
Those numbers may not seem like a lot, but in a month that’s a decent move.

And, it’s notable because sharp contractions in the yield curve are usually indicative of

1) Impending slow economic growth/recession and/or

2) Deflation. 

The flattening of the curve, which is coincident with the commodity collapse in July, is especially notable.

To be honest, if I were on a desert island and someone told me the yield curve is flattening like crazy and commodities are collapsing, I’d tell them to watch out.

So, the logical question is:

“Should this make us rethink risk asset allocations and short bond positions?”  

I believe the answer is “No, not yet,” and here’s why:

I am certainly not going to say, “It’s different this time,” but there are some unique events to consider that are contributing to this flattening of the curve.

First and foremost, it is indicative of the market finally admitting the Fed wants to raise rates while still holding out the opinion that the Fed will remain dovish longer term (so the bond market pricing in the “One and Done” Fed strategy).

Here’s the reason I say that.

Point #1:   2-Year Treasury yields have actually risen since July 2, and are basically at the highs for the year.

That’s because the bond market is coming to grips with the fact that the Fed wants to (and probably will) raise Fed Funds in September. 

Fed Funds increases hit short-term debt the hardest, and that’s why the 2-Year Treasury has sold off (and yields stayed near the highs of the year).

Point #2:   10-Year Treasury yields have dropped 20 basis points since July 2 (about 8%) while 30-year yields have fallen about 30 basis points (a little under 10%).

So, the longer end of the curve has seen yields fall more (and a bigger increase in bonds) and that is because while the bond market is starting to admit the Fed will raise rates, it’s counter-acting that by assuming the pace of rate increases will be slower than previously thought.

As a result, investors are buying the long end of the curve to try and capture yield.

Importantly, since July 2 the bond market has adopted the idea that the Fed will raise rates more slowly over the coming years than was previously thought. The commodity decline and China weakness are probably reasons, and therein lies why I remain a bond bear.

First, I think it is a big stretch to assume that China and the commodity decline are going to be material enough to warrant the Fed raising rates more slowly over the coming quarters and years—I just think predicting that is very difficult.

Second, under the surface, inflation has shown signs of firming, and like rocks rolling down a hill, it’s starting to slowly gain momentum.

While no inflation has been with us for years, I believe “inflation” broadly has troughed, and if anything will move higher over the coming months and quarters. At this point, the longer term risk is of higher inflation, not lower inflation.

Case in point, while Monday’s Core PCE Price Index was 1.3% year over year, looking at the pace for just the last six months (so annualizing the last six-month pace) the year-over-year gain jumps to 1.8%. Point being, inflation pressures are firming.

Bottom line, what’s going on in the bond and commodity markets is something to watch closely, but this idea that the Fed will automatically be more dovish over the months and quarters ahead seems like an aggressive assumption, especially given the current level of yields and inflation.

Regardless, we will be watching the yield curve closely, and obviously we’ll alert you to any changes that might warrant more defensive positioning.

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Your Job is to Get Clients and Raise Assets – Let Us Watch the Bond Market for You

This is the type of short, succinct, plain English bond market analysis we’ve sent to paid subscribers of The Sevens Report since April.  And, we are committed to helping them navigate this tectonic shift in the fixed income markets successfully – so they can further solidify relationships with their current clients, and be able to get new clients.

Every day we watch the bond market (as well as the stock market, commodities markets, currencies markets and economic data) so that our subscribers don’t have to, and that’s why we believe The Sevens Report offers the best value in the independent research space.

Subscribers to The Sevens Report (Top FAs, RIAs, Portfolio Managers, and sophisticated investors) trust us to tell them when something in those markets is going wrong, and to identify specific opportunities to help them outperform.

The rate hike is coming.

Make sure you have an independent analyst that you can trust to 1) Make sure you’re alerted to warning signs for stocks and bonds, and 2) Provide tactical investment strategies to protect portfolios from market volatility and help your clients outperform.

If all we do is help you successfully navigate this market over the next three months, it will be more than worth the $65/monthly subscription cost ($195 total).

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Best,
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Tom Essaye,
Editor of The 7:00’s Report

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