Interest Rates

A distinguishing feature of fixed income securities is that the expected return on a bond over its remaining lifetime is known with considerable certainty at the time of purchase. This characteristic can be a blessing or a curse, the negative aspect coming into play during an asset price bubble. Equity investors can justify almost any price as they dream of boundless riches arising from the bubble’s driving theme, limited only by their imagination. However, a bond’s yield to maturity is known at the time of purchase and this is the return investors in aggregate will earn. Even during the euphoria of an asset bubble, the expected outcome - the return of par value at maturity - is also the best-case outcome, and that is where our story begins.

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Here we evaluate the returns of fixed-income ETFs since the Fed began its boosting campaign last March; for many mainstream offerings, the picture is not a pretty one. We recap the pain felt by investors in conventional fixed-rate bond funds.

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One of the most vivid memories of the Great Depression is the sight of nervous depositors lined up outside a bank hoping to withdraw their meager savings before the bank failed.  Like a rare tropical disease that was thought to be eradicated by modern medicine, the classic bank run reappeared this month in the form of Silicon Valley Bank.  At the beginning of March, the market had no particular concerns about the potential for systemic bank failures, but SVB’s sudden demise has cast a pall over the entire industry.

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We scrutinized the typical path of money growth during the four-year presidential election cycle, and found that it typically tends to bottom out in October of the midterm year! The cycle says a monetary pivot is imminent, and the average pattern traced out by M2 suggests an acceleration in the growth rate of about 2.5% leading up to the presidential election. 

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We’ve heard no references lately to the famous “Fed Model” for stock market valuation. We think we know why: The model’s usual proponents probably don’t like its current verdict—which is that stocks are far more expensive than at the early January market peak.

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“Don’t fight the Fed” was profitable advice dispensed almost daily by bulls in the 2nd half of 2020 and all of 2021. It’s been valuable advice in 2022, as well. However, when the Fed turned hostile earlier this year, the bulls deviated from their own sound advice and looked for new narratives.

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The LEI’s 3.6% six-month annualized loss through September 2006 was the largest decline not followed almost immediately by a recession. This year, the LEI contracted by 3.7% over the six months through June—if a recession is avoided in the current experience, it would be the most misleading signal in the history of the LEI as currently constructed.

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Like Gonzaga in the NCAA basketball tournament, stock market bulls are set for their first real test in a very long time.

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It’s been so long since investors have faced a serious Fed tightening episode that they may have forgotten a helpful rule of thumb: An initial hike in the fed funds rate is usually a good excuse to dump some Consumer Discretionary stocks. 

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High yield bonds returned a robust 15.4% in the year ending June 30, extending a winning streak that produced a 56.4% cumulative return since the end of 2015.  After a quick, severe drawdown at the height of the COVID-19 scare, junk bonds have experienced nearly ideal market conditions, heralding a return to trends that have been in place for several years. The post-pandemic move toward this record low has been a boon to high yield bond investors, but it has also created a significant risk of reversal.  We believe most things in the financial markets are defined by cycles, with Treasury yields and credit spreads no exception.  Tight readings for both rate series demand that we consider the possibility that a cyclical reversal could weigh on junk bond prices going forward.

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We’ve long considered ourselves lucky to have escaped from our graduate-economics program after only a year. Among the few nuggets we managed to retain was the startling conclusion to a paper written by a famed department professor asking, “Do Large Deficits Produce High Interest Rates?”

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High yield corporate bonds returned over +15% for the twelve months ended June 30th, building on a strong five-year run that was interrupted by a short, but painful, drop at the onset of COVID-19. Chart 1 indicates that high yield bonds compound at a remarkably steady rate, with infrequent but severe drawdowns during times of financial stress.

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The liquidity and interest-rate backdrop for stocks has been favorable to such an extreme that we’ve cautioned any minor diminution in this condition could trip up the stock market. On that score, the monetary aggregates and the Fed’s balance sheet don’t pose much concern. On the other hand...

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Often, what market pundits like to pass off as bold, contrarian forecasts are merely rationalizations and extrapolations of trends that have already been in place for some time.

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For almost nine months, an historic Fed liquidity flood has washed away any economic, valuation, technical, or “sentimental” stock market challenges. Nonetheless, each economic disappointment brings hope this flood will intensify. Those hopes aren’t irrational, because when it comes to any measure of liquidity, rate of change is more important than level.

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The first up-leg of the bull market has catapulted many Large Cap valuations to levels seen only in 1999, 2000, 2019, and pre-pandemic 2020. At the six-month point on September 23rd, the S&P 500 P/E on 5-Yr. Normalized EPS had already reached 26.9x—a reading that is 30% higher than at the same point of any other bull market.

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We review the somewhat out-of-character performance of the Utilities sector to try to pinpoint what is influencing results. This article touches on several potential drivers for the sector’s relative strength.

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The bull case for a “brief” pandemic-related recession and powerful recovery is the same as the bull case from two months ago for “no recession or bear market” at all: stimulus (as if that’s exactly what the U.S. economy has lacked for the last 11 years).

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The fear (or hope) that U.S. bond yields would fall to zero or below subsided over the last month. However, the belief that low yields merit significantly above-average P/E ratios remains stronger than ever.

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We always do our own work and draw our own conclusions. Lately, though, we’ve wondered what the late “Monetary Marty” Zweig might say about the stock market’s current liquidity backdrop.

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