Is The Fed Setting Up A Nasty Surprise For Bonds?

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Summary

Fed is waiting for more clarity around President Trump’s fiscal policy.

High chance of a hawkish Fed in June and the first increase in the benchmark rate.

Lessons from the 1950s' bond market.

Selling your bond portfolio for riskier assets is not prudent risk management.

As expected, the U.S. Federal Reserve kept short-term interest rates unchanged at its first meeting since President Trump took office. There is uncertainty surrounding President Trump's fiscal and economic policies, so it is not surprising that the Fed will hold off on a rate hike until there is greater clarity. But the markets still expect the Fed to pursue a more aggressive hiking cycle. In fact, the Fed could raise rates three times in 2017.

What does this mean for bonds? How have bonds reacted during past rising rate cycles?

The Fed and politics

The Fed had nothing new to say at its latest policy meeting. They reiterated the strength of the labour market and that economic activity is expanding at a moderate pace. I expect they will stick to that same message until Fed officials agree on a rate hike. This decision did not surprise the financial markets. The Fed Fund futures market priced the probability of a February rate increase at only 4%.

It makes sense for the Fed to wait and get greater clarity surrounding President Trump's fiscal and economic policies. No one knows if Congress will approve his agenda, including fiscal stimulus, deregulation, infrastructure spending and steep tax cuts. There are also plans to change trade policies such as NAFTA and this could raise economic uncertainty. And we all know how dovish the Fed becomes at times of economic uncertainty.

For instance, the Fed originally projected raising rates four times last year, but there was only one rate increase. The Fed did not raise rates because of growing U.S. and global economic uncertainty. The "meltdown" in China, the sell-off in oil prices, the U.K.'s Brexit vote and the two-year-long U.S. presidential election put rate hikes on pause. There is a possibility of similar black swan events to hold off higher rates in 2017. But market sell-offs, like the one seen earlier last year, are impossible to predict.

What we do know is that President Trump's fiscal stimulus and tax reform, if enacted, could have a lasting impact on the rate of inflation. Inflation, as measured by change in the personal-consumption-expenditures price index, has risen to 1.7%. This is short of the Fed's preferred inflation target of 2%. A stronger U.S. economy under President Trump, combined with recovering energy prices, could accelerate the rate of inflation, and make the Fed hike rates at a much faster clip.

The Fed offered no clues at the latest meeting as to when they might act again, and as mentioned above, they want more clarity on fiscal policy. The Fed Fund futures markets are ruling out a rate increase in the first half of 2017. The markets expect a more hawkish Fed in the second half of the year, with the first 25 bps bump in rates coming in June, with a 46.7% probability. By June, there should be more clarity on fiscal policy.

The Fed at the December policy meeting projected three hikes of 25 bps each to reach 1.25% to 1.50% by the end of 2017. The Fed Fund futures market prices the probability of this happening at less than 25%. The markets are pricing only two rate increase in 2017, assuming no black swan risks and the economy stays on track. In the long run, the Fed's "dot plot" suggests interest rates could climb to around 2.75% and 3%.

When the Fed starts to raise rates, what does this mean for bonds, and how have bonds reacted during past rising rate cycles?

Lessons from the 1950s

Treasury bonds and bond funds, like the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG) have been selling off in response to the Fed's expected monetary tightening and reflation risk. Yields for the 10-year Treasury bond, which increases when bond prices decrease, hit 2.47%, and have nearly doubled since bottoming in July 2016. You could draw comparisons of today's bond market to the 1970s period of rising rates and inflation. But that would not make sense since the yield on the 10-year Treasury bond was 8% in 1975 and 10.39% in 1979.

I think the better comparison would be the 1950s when the 10-year Treasury yield gradually climbed from 2.39% in 1950, to 2.96% in 1955, and peaked at 4.69% in 1959. Inflation, as measured by the core PCE price index, was 1.4% in 1950, and slowly ran up to 2.2% in 1959. Inflation averaged 2% annually in the 1950s, which is in line with the Fed's inflation target at 2% for 2018 and 2019. How exactly did the stock and bond markets perform in the 1950s during the rising interest rate and inflation cycle?

Stock and bond performances from 1950 to 1959

Nominal returns

S&P 500

10-year Treasury bond

3-month Treasury bill

Average return

20.93%

0.83%

1.97%

Best return

52.56%

6.80%

3.26%

Worst return

-10.46%

-2.65%

0.96%

There is a lot of talk about how rising interest rates will cause massive losses in bonds. Historical data does not necessarily support that thesis. In the 1950s, 10-year Treasury bonds had a total of five negative-return years. The worst return was in 1959 at -2.65%, but on average, the 10-year Treasury gained 0.83%. Cash in short duration Treasury bills, on average, returned 1.97%. Short maturity bonds tend to outperform long-dated bonds in rising rate environments. The price of short-duration Treasuries or bond funds is less interest rate sensitive than those with a longer duration and maturity.

These are not the greatest of nominal returns. Nonetheless, I think it shows that the negative sentiment in today's bond market is overexaggerated. Fixed income investors might expect to see more volatility and lower bond returns, causing them to panic-sell their bond holdings. This is not prudent risk management. Selling bonds will only magnify their equity risk exposure. Bonds serve a purpose in people's portfolios and that is to generate a safe stream of income and to diversify equity risk.

For instance, stocks, as measured by the S&P 500 (NYSEARCA:SPY), were in a bull market in the 1950s, but recorded negative returns in 1953 and 1957. Bonds ended up outperforming the S&P 500 in both years and protected people's portfolios from the volatility and losses in the stock market. The S&P 500 continued to climb for several more years until the bear market in 1973-1974. Bonds once again offered downside protection from the volatility during the stock bear market.

Nominal returns

S&P 500

10-year Treasury Bond

3-month Treasury Bill

1953

-1.21%

4.14%

1.89%

1957

-10.46%

6.80%

3.23%

1973

-14.31%

3.66%

6.73%

1974

-25.90%

1.99%

7.78%

Takeaway

The back half of 1981 featured a declining Fed funds rate and what many consider as the beginning of the 35-year bond bull market. Many are predicting that bond bull run will come to an end because of the reversal of record-low interest rates and reflation risk. I believe the so-called "great rotation" into equities and out of Treasuries and bond funds is overblown. There is weak historical data that shows bonds incur huge losses over long-term cycles of rising rates. In fact, Treasury bonds have seen positive average nominal returns every single decade.

Considering the Fed Fund futures market is pricing at least two rate hikes in 2017, what can investors do to decrease their short-term losses? The rise of interest rates might encourage fixed income investors to reinvest at higher rates and shorten the duration of their bond portfolios. Short maturity bonds are less price-sensitive to interest rate changes. If you think there will be a slight rise in inflation under President Trump, I recommend to look at Treasury inflation-protected securities (NYSEARCA:TIP).

All in all, I highly discourage investors to rotate out of a diversified fixed income portfolio into riskier assets like stocks because of higher returns. Getting rid of your bonds for stocks will not only inflate your equity risk, but it will completely change your risk tolerance and increase the standard deviation of your portfolio.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.