The Bond Bear That Cried Wolf by Jay Leopold, Columbia Threadneedle Investments
- For the past several years, bond bears regularly cautioned the Federal Reserve’s zero-interest-rate policy was unsustainable, calling for higher rates in the foreseeable future. Bond investors have become gradually more cautious over the past year.
- In contrast, until the past month, equity markets had not discounted an initial round of Fed tightening like other markets.
- The recent violent correction reflects a rising risk premium being built into equity prices that had already existed in other areas of global markets, and it is a healthy response.
Almost every child knows the Aesop’s fable “The Boy Who Cried Wolf.” As the ancient story goes, a child tending sheep mischievously alarmed others of a potentially dangerous threat by crying “WOLF!” The town folk rushed to protect the flock, realized it was a false alarm and went back to their business. Several other times the boy cried, the neighbors again came running. Each time, the alert was misplaced. One day, a real wolf appeared. The panicked boy screamed for help. But weary of the incorrect alarms, the community ignored the warning and the sheep were eaten.
For the past several years, bond bears regularly cautioned the Federal Reserve’s zero-interest-rate policy was unsustainable, calling for higher rates in the foreseeable future. Since markets often discount changes to future economic growth many months in advance, these warnings periodically gained traction with investors, prompting longer-term rates to briefly spike or the equity markets to suddenly correct. Each time, the rate rise was pushed further into the future. Like the boy in Aesop’s fable, the bond bears’ cries proved wrong and investors put risk back in the portfolio by bidding up stock prices and narrowing credit spreads.
However bond investors have become gradually more cautious over the past year, demanding wider spreads over Treasuries in investment grade (as seen below in Exhibit 1). The same is true for high-yield bonds, although weakness in the energy sector has been a contributing factor in this space.
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Exhibit 1: Barclays investment-grade-to-5-year-Treasury spread
Other parts of the capital markets also have begun to discount higher rates. The dollar has strengthened, creating ripples in the form of weaker commodity prices, slower emerging markets economic growth, and a currency devaluation in China, which was already struggling to keep its economy growing at targeted levels.
Until the past month, equity markets had not discounted an initial round of Fed tightening like other markets. As seen in Exhibit 2 below, valuation levels continued to expand to levels rarely seen in the past 20 years (barring the tech-bubble driven period between 1997–2002). I believe the recent violent correction reflects a rising risk premium being built into equity prices that had already existed in other areas of global markets. In effect, equity investors may have heard the cry of wolf (rising rates and its resulting ripples) so often that they grew complacent to the dangers.
Exhibit 2: S&P 500 Index price-to-forward-earnings ratio
So where do we go from here? I believe this correction is healthy, providing a necessary reminder that investing is not a risk-free endeavor. Without it, valuation levels may have kept creeping to even more unsustainably high levels, making any future re-setting more painful. In addition, the real danger isn’t in the Fed boosting short rates a couple of times from current levels, but a sudden or more sustained rise.
There is little evidence that a significant economic slowdown is coming in the United States. And for the first time in a while, a number of stocks appear increasingly attractive. For those with a shorter time horizon, equity prices may be closer to a bottom than a top, and may even be set up to rally if the Fed raises rates in September.
But roughly seven years of unprecedentedly low interest rates may have created some larger structural complacency and some ill-advised investment decisions. Valuation levels have come down but are far from historic lows. It is conceivable that hedge funds or other investment vehicles that levered up significantly on the assumption of continued low rates and low volatility might be confronted with a new environment that will cause a rather unpleasant outcome for them, like Long Term Capital Management in 1998. This is not meant to be a prediction, but merely an example of risks that might exist as the global economy and interest rate structures work their way back toward “normal.”
The ability to unwind the current extraordinarily easy monetary policy has never been tested, and the eventual outcome is far from certain. Consequently, an appropriately wide margin of safety based on each investor’s long-term risk tolerance may be warranted before a significant increase in risk levels in a portfolio is justified. After all, the next time “WOLF” is cried, it might be the real deal.