What's Behind the Bond Market Turmoil?Published: July 30, 2003 in Knowledge@Wharton
Summer is supposed to be an easygoing time of naps in the sun, good books and trips to the beach. But since vacation season got underway in June the bond market has been anything but laid back. Investors have grappled with steep declines in bond prices, sharply rising interest rates and confusion over Federal Reserve policy, which led to a lack of confidence in the Fed on the part of fixed-income investors.
Wharton faculty members, bond-fund managers and economists say, however, that it is important to put the roiling bond market in perspective. The market had been riding the bull for more than two decades before this year’s drop in prices, and there was an ever-present risk -- despite the steady optimism of some investors accustomed to good times -- that rates would at some point start to rise.
Despite their dramatic increase in June and July, rates dropped back a bit the week of Aug. 4 and remain low by historical standards. Indeed, the rate on 10-year Treasury bonds today is about what it was before the market went haywire. In the months to come, though, rates will rise, these experts told Knowledge@Wharton, a scenario that could curtail spending on homes and other goods and put a crimp in the economy’s expansion. Nonetheless, the economy appears to be gathering enough momentum to strengthen. “I think we saw the absolute low of yields in June and we will not see those yields for many, many years,” says Wharton finance professor Jeremy J. Siegel.
Marshall E. Blume, professor of financial management and director of Wharton’s Rodney L. White Center for Financial Research, says it is “not a sign of disaster that interest rates might be going up. There are good reasons for interest rates to go up. If the economy is growing, rates go up and that’s not bad.”
“I still believe a rise in rates is, in part, just getting back from an extraordinary [bond-market] rally that took rates too low,” says Stuart G. Hoffman, senior vice president and chief economist at PNC Financial Services. “While rates -- even mortgage rates -- are back up, they aren’t at levels that threaten the economic expansion in any way, shape or form. Rising rates in some ways represent some perceived improvement in the economy. Real interest rates rise when the economy is expected to do better.”
William Reynolds, director of the fixed income division at T. Rowe Price Associates, says: “Our thinking is that August will not be a particularly volatile period. The backdrop is the economy is getting stronger, and we’ll probably see 3.5% to 4% growth [in gross domestic product]. In that environment, the perception about the Fed will start to change, and you would anticipate a tightening profile on their part, and rates will probably drift higher. We are still at fairly low interest-rate levels on a relative basis.”
In an Aug. 4 market commentary, Bob Doll, president and chief investment officer of Merrill Lynch Investment Managers, wrote: “While the move up in interest rates is not a surprise to us, the speed of the run-up is. The economic backdrop is improving but not in a way to continue the type of sell-off in bonds that we have seen.”
Fed Funds Rate Unchanged
As expected, the Fed announced on Aug. 12 that it would leave its benchmark federal funds rate unchanged at 1% and that it intended to keep interest rates low for a "considerable period." The central bank also said that the risk of deflation, though low, would remain its chief concern over the near term.
In a statement following its regularly scheduled meeting, the 12-member Federal Open Market Committee said it continues to believe that an accommodative monetary policy, coupled with continued “robust” growth in productivity, “is providing important ongoing support to economic activity.” It said spending by consumers and businesses is firming, although labor-market indicators were “mixed.” It also said that business pricing power and increases in core consumer prices “remain muted.” The Fed added that “the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal” and that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future.”
In Siegel’s view, the FOMC -- in deciding to keep rates unchanged and in the typically cautious verbiage that it used -- was “trying to walk a very fine line.”
“They wanted to show that they are encouraged by some news but not so encouraged that they’re going to start thinking of raising rates,” says Siegel. “They’ve been worried about the bond market and the rise in rates and they’re trying not to worry the bond market. They were a little bit taken aback by the tremendous rise in bond rates since the last meeting [of the FOMC on June 25]. They’re just a little worried that a rise in bond rates could kill off economic recovery, so they want to talk the bond market down a little bit here.
“Basically, the Fed wanted to tell people it has no plans to raise rates. The bond market will eventually decide if that will happen. My feeling is that, although their intention is to keep rates low for a long time, if the economy recovers, I don’t think they’ll be able to hold rates that low.”
Explaining the Volatility
Experts interviewed by Knowledge@Wharton say this summer’s stunning volatility in the bond market can be traced to the spring, when the Fed indicated that the rate of inflation, about 1%, was low and that the economy was possibly at risk of deflation. Even if the economy began to gather more steam, the Fed said at the time that it would keep short-term rates as low as it could for as long as it could. By raising the specter of deflation, the Fed encouraged a rally in bonds. The rally drove bond prices up and yields on the 10-year U.S. Treasury bond down to nearly 3% in May. Another factor that came into play was the war in Iraq, which made investors risk-averse.
At its June 25 meeting, however, the FOMC seemed to abandon its view that deflation was a possibility. It decided to cut its target for the federal-funds rate by just one-quarter of a percentage point -- from 1.25% to 1% -- instead of the half point that bond traders had anticipated. In July, the Fed caught traders off guard again by deciding not to take an action that the market had expected. Traders had thought the Fed was poised to take the unusual step of buying Treasury bonds outright in an attempt to engage in what bond mavens call “yield management.” But that did not happen.
“The market said, ‘If the Fed doesn’t want [bonds], we’ll sell them,’” recalls Gregory Davis, a portfolio manger at the Vanguard Group. The ensuing sell-off drove prices down and yields up. (A fundamental characteristic of bonds is that yields move in the opposite direction of prices.) From mid-June through Aug. 11, the yield on the 10-year Treasury bond rose from 3.116% to 4.38 % -- an increase of about 40%. “That is the kind of decline [in bond prices] you don’t see that often,” Davis notes. “The decline we saw in the 10-year alone was an all-time retrenchment” in such a brief period of time.
“We had a huge rally in the bond market in April and May and interest rates fell,” Hoffman explains. “Short-term rates were lower than in 40 years and long-term rates were lower than they have been since the late 1950s. So we had this tremendous rally.” He adds that the rally was probably overdone, as was the subsequent sell-off. “The market had probably gotten carried away.”
For his part, Siegel takes issue with the suggestion that Fed Chairman Alan Greenspan erred by “miscommunicating” FOMC intentions and causing the recent bond-market bubble. “In my opinion, nothing could be further from the truth,” Siegel wrote in an Aug. 8 commentary published on his website, JeremySiegel.com. “It was the bond market that overreacted to the Fed’s statements about ‘unconventional easing.’ Given the anxiety about whether the Fed was ‘out of ammunition,’ it was very appropriate for Greenspan to ease the minds of investors by making those statements. Greenspan never said it was likely he would use them.”
Also contributing to the bond-market’s volatility this summer was a third component: mortgages. As yields on mortgages declined, homeowners rushed to refinance. This was a smart move by homeowners, but it caused problems for the bond market in that the massive refinancing affected what is known as the “duration” of mortgage-backed bonds. (Duration is a measure of the sensitivity of bond prices to movements in interest rates. If a bond has a duration of two years, for instance, its price would decline by about 2% when interest rates rose by 1 percentage point. By contrast, the bond’s price would rise by about 2% when interest rates fell by 1 percentage point.)
Changes in duration represent risk, and risk is something that bond investors try to hedge against. As mortgage rates rose this summer, the duration on mortgage-backed bonds got longer, which prompted portfolio managers and other institutional investors to sell Treasury securities as a hedge, thus putting upward pressure on rates. “Managers had to rebalance their portfolios and this created more hedging,” says Davis.
“Within the internal dynamics of the market, a lot of people hedge mortgages,” agrees Hoffman. “They had to buy Treasuries to guard those hedges. That’s the kind of inside baseball that causes markets to sell overdramatically. They sometimes force buyers and sellers to extremes. That’s another reason the market has been beat up badly.”
How high and how fast interests rates will climb in the next six to 12 months will hinge on several factors -- the pace of economic recovery, the pace of consumer spending, inflation, and the actions of bond investors, including foreign investors, who own a huge percentage of U.S. Treasuries. Several people interviewed by Knowledge@Wharton predicted 3.5% to 4% growth in GDP during the last six months of 2003.
“In an improving economic framework, it’s hard to imagine interest rates staying at these lower levels, so they’ll probably drift higher,” says Reynolds of T. Rowe Price. “How long and how high that movement will be will depend on a battle between the deflationary themes of globalization of world trade and a stronger economy theme in the U.S. It’s hard to say today what our environment’s going to be like six months from now, but it’s reasonable to conclude we’ll have a firmer economic environment and in such an environments rates will [drift higher].”
Wharton’s Blume says inflation may turn out to be a bigger factor in affecting rates than many assume. “In the past three or four months there’s been some indication that the economy is going to get better, and if that happens there may be some inflationary pressures, which can make interest rates rise. I was surprised that rates were that low [earlier this year]. People were on a bandwagon and thought inflation was licked forever and ever. But I’m not so sanguine about that.”
Blume also worries that the U.S. trade deficit is “outrageously high” vis-à-vis any number of nations, including Asian countries, which are both major trading partners and major investors in Treasuries. “As long as foreigners are willing to keep our dollars, great,” Blume says. “But somewhere on the horizon there’s a possibility of China floating its currency, which would be a devaluation more than likely. That would increase the costs of our imports from China dramatically, which would have some impact on inflation.”
Siegel says he foresees no major selling of Treasuries by foreign investors. “All countries running trade surpluses with us, China in particular, have to put their money somewhere, and the safest place is U.S. government bonds,” Siegel says. “Now they’re taking a loss, so will they panic and get rid of the dollars and maybe go to euros? Dollars are still much more preferred by the Asian countries running surpluses.”
Siegel thinks that the level of GDP growth will have a major impact on bonds going forward. “A stronger economy will send rates up,” he says. “Whenever you see a strong economy, you’re going to see higher rates. If there were a terrorist attack, you’ll see rates go down because economic activity will be thwarted and the Fed will become accommodative to stimulate the economy.” Siegel predicts that the economy “will get stronger. I think second half is going to be good.”
Davis of the Vanguard Group expects rates to continue to rise, but at a slower pace. "I think in the medium term they’ll be driven by economic data," he says. "As that data comes out, that will give us a better sense of what’s going on in the economy -- whether unemployment will decline and consumer confidence will strengthen.”
Hoffman, the PNC economist, wrote in a recent commentary that while some analysts worry that rising interest rates may restrain consumer spending, he believes these fears appear overstated. “By raising disposable income, the recent round of tax cuts has freed up extra cash for consumers,” he notes. “Moreover, while mortgage rates have risen, rates on other types of consumer debt (such as home equity loans, auto loans, and credit card debt) are tied to short-term interest rates. With the Federal Reserve unlikely to raise short-term rates before this time in 2004, the impact of higher mortgage rates on overall debt service burdens will be limited. Thus, while rising long-term interest rates may lead to a slower pace of growth in consumer spending, they are highly unlikely to lead to an outright decline in spending, especially if job growth resumes as we expect.”
A more serious threat to sustained growth in consumer spending would be continued weakness in the job market, according to Hoffman. The U.S. Labor Department’s July employment report showed a loss of 44,000 jobs, but recent numbers showing a decline in initial jobless claims offer hope of a modestly improving job outlook. “Still, labor markets will remain weak without a significantly faster rate of economic growth,” Hoffman writes. “This will keep the Fed vigilant and further cuts in short-term interest rates cannot be ruled out. Our view, however, that no further short-term rate cuts will be necessary is bolstered by the Fed’s own forecast, which foresees an even faster rate of economic growth than does our trend growth forecast.”
Even so, other factors also affect the economic outlook. Wharton finance professor Franklin Allen points out that uncertainty abroad and political decisions in Washington will continue to affect the bond market. “It’d be nice if we got rid of all the political uncertainty,” he says. “It would be nice if they got Osama bin Laden and Saddam Hussein. The amount of money the government is spending in Iraq is a huge uncertainty for the bond market. The U.S. fiscal position has gotten so bad so quickly, with a lot of money being spent on Medicaid and guaranteed prescription drugs. It would be great if a lot of that uncertainty went away.”