When the Metrics Don't Fit

by Brad Houle, CFA Executive Vice President

Investor confidence rallied the S&P 500 this week with the index climbing to all-time highs mid-week and returning more than one percent by the week’s end. Bonds were lower in price and higher in yield with the 10-year Treasury moving from a 1.43 percent yield on Monday to a 1.59 percent yield at the end of the week.  Retail sales for June were stronger than expected and the Citigroup Economic Surprise Index recently hit the highest level since January 2015.

We have had a number of client questions regarding the article titled "Can We Ignore the Alarm Bells the Bond Market is Ringing" published in the July 11, 2016 edition of The New York Times. The essential thrust of the article is that, using traditional metrics of looking at global bond markets, we are in store for a serious global recession. However, due to the amount of accommodative monetary policy worldwide, the traditional metrics don't apply.

Bond prices are not being set by markets, but rather by bureaucrats in different countries and in different currencies. To deal with the global malaise left over from the financial crisis, central banks around the world have been using quantitative easing in an attempt to stimulate economies. This strategy has been moderately successful in the United States if you look at unemployment and the strength of the consumer economy.  In other locations the strategy has had more of a mixed success. The jury is still out on the efficacy of quantitative easing in Japan and Europe longer-term.

One of the results of quantitative easing is a prevalence of negative interest rates worldwide. Bonds totaling $10 trillion and representing 14 different countries, one third of the world’s sovereign debt, now have a negative yield. As a result of these low interest rates U.S. Bond yields are very attractive to global investors. The United State 10-year Treasury at 1.50 percent is a compelling buy to an investor relative to a Swiss Franc denominated 10-year bonds with a -0.40 percent yield. If an investor buys this bond and holds it to maturity they will get back less than they invested. This calls into question the concept of the time value of money.

The United States is essentially importing low interest rates from abroad. As global investors buy U.S. Treasury bonds the prices rise causing the yields to drop. As a result, we do not believe the traditional signals regarding the economy gleaned from the bond market are reliable.

Our Takeaway for the Week

  • Central Bankers are setting interest rates, not the markets