We are approaching the end of the third quarter, and it has been eventful and somewhat confusing for everyone. It would be easy to get lost in the detail, but that would serve little purpose. We hope you are doing well and not allowing recent economic and market headlines to create anxiety for you.
We won’t delve into all of the issues today, but some of the big ones we see include:
- Higher-for-longer Fed policy
- Sticky inflation
- Rising interest rates and an inverted yield curve1
- UAW strikes
- Government shutdown looming
- Commercial real estate in difficulty2
- Rising oil prices
- Record credit card debt and rapidly rising default rates3
If you are interested, we have linked a number of Wall St. Journal articles on these topics below.
But What About Bonds?
We are getting questions about bonds from clients lately, often enough that we thought a short explanation was in order.
- In past years we were asked “why not more equities?” since bond yields were low.
- Now the question has become “why not cash?” since cash yields are as high as the newly-raised bond yields and bonds prices have declined.
The answer to the first question was simple (if not easy)—adding more equities increased risk beyond the level the investor had chosen. Even after several bad years for bonds, extreme years, we can readily see that bond downside is nothing like the risk of equities, where losses can be far larger.
The second question is more subtle. One could argue that you are reducing risk while maintaining yield, as taxable cash yields of around 5% are very close to the 30-day SEC yield from bond funds like PIMCO Total Return. It all goes to what is called the “inverted yield curve.”
Geez, Roger, Are You Going to Get All Technical On Us Here?
I approach this topic with caution born of long experience; a lot of people glaze over when we discuss topics like this too much. And I don’t blame them—they wanted comprehensive advice and portfolio management, not a lecture on bond math!
But in order to address this question, the inverted yield curve should be simply explained.
Right now the two- and ten-year Treasuries are yielding about 5.12% and 4.54%, respectively.4 That is not normal; you usually get a better yield on the longer bonds. But these are not normal times.
The two-year Treasury yield is strongly affected by the Fed Funds rate, which is not a market rate at all– it is set by the Fed. Fed Funds are in the 5.25-5.5% range right now, thus the two year has a similar yield.5 The Fed has tightened very sharply and driven short-term rates up a lot.
But the longer-term bonds have lower yields, essentially forecasting a decline in the two-year yield which would be driven by an easing of Fed policy, which would likely be caused by a weak economy and lower inflation. And next year is an election year. Who can say what effect that will have on Fed policy?
So, What Does This Mean to Me?
An inverted yield curve is widely considered to forecast a recession, which would likely bring short rates down sharply. Buyers of bonds clearly prefer longer bonds, which lock in these higher yields and require a premium to invest in short bonds, with the expectation that these yields will not last long.
If you have held a market duration bond portfolio, you had some capital losses last year, and are relatively flat this year after the recent increase in yields. If we do see a slowdown or recession and falling rates, you will make some of that back. On the other hand, if you try to time the interest rate cycle and go short duration now, you might miss some of that recovery.
Keep in mind that bonds outside the “core” bond category, like high yield and emerging markets bonds, are less sensitive to rising rates and have modest gains for the year.
What Should I Do?
First of all, keep it simple; don’t try to time these changes.
Second, remember you have a long-term strategy in place, and these short-term fluctuations will wash out over time if you stay the course.
Third, if it makes you feel better taking some fraction of your bonds and shortening the duration, it will not make that big a difference, and we can help you do that. We are not recommending that, but it would be OK if you feel strongly about it and discuss it with your advisor.
The most important thing is to maintain your strategy through challenging times (aren’t they all?). A steady course will get you through all of these events and minimize the stress you might feel about it.
Additional Resources:
- U.S. Economy Could Withstand One Shock, but Four at Once?
- Why America Has a Long-Term Labor Crisis, in Six Charts
- Why Are Tech Stocks Down? Bond Yields Are Up
1. Langley, Karen. “The Tech Trade Is Showing Cracks. Higher Rates for Longer Spell More Trouble.” WSJ, 17 Sept. 2023, www.wsj.com/finance/stocks/the-tech-trade-is-showing-cracks-higher-rates-for-longer-spell-more-trouble-313c1a4d
2. Shifflett, Shane, and Peter Santilli. “Watching the Real-Estate Bust From the Streets of San Francisco.” WSJ, 24 Sept. 2023, www.wsj.com/real-estate/commercial/watching-the-real-estate-bust-from-the-streets-of-san-francisco-9708bb91.
3. Fox, Michelle. “Credit Card Losses Are Rising at the Fastest Pace Since the Great Financial Crisis.” CNBC, 24 Sept. 2023, www.cnbc.com/2023/09/22/credit-card-losses-are-rising-at-the-fastest-pace-since-the-great-financial-crisis.html.
4. Kiderlin, Sophie, and Alex Harring. “Treasury Yields Retreat as Investors Assess Economic Outlook.” CNBC, 22 Sept. 2023, www.cnbc.com/2023/09/22/us-treasury-yields-investors-assess-economic-outlook.html.
5. “Effective Federal Funds Rate”. Federal Reserve Bank of New York, September 26, 2023. https://www.newyorkfed.org/markets/reference-rates/
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