KEY TAKEAWAYS
- Europe bond weakness spilled over to the U.S. as investors look past week domestic data and forward to a better second half of 2015.
- Fading U.S. dollar strength, better growth in Europe, and the rebound in oil prices point to a reversal of the lower inflation expectations that powered bond strength for most of 2014 and early 2015.
Made in Europe
by Anthony Valeri, Chief Investment Officer, LPL Financial
A weak finish to the month of April 2015 was “made in Europe” as expectations of better global growth weighed on bonds. On Monday, May 4, 2015, the 10-year German government bond yield closed at 0.45%, more than quadrupling over the past two weeks. European strength combined with a dovish Federal Reserve (Fed) meeting outcome continued to arrest U.S. dollar strength, a primary driver of the steady decline in inflation and investors’ inflation expectations from mid-2014 through the first quarter of 2015. In turn, forward-looking financial markets anticipate that a halt in U.S. dollar strength may not only help reverse inflation expectations, but also remove a burden to profit growth of multinational U.S. companies.
European market moves overshadowed another round of weaker than expected U.S. economic data, which would normally have supported bond prices. Although a soft reading on first quarter 2015 economic growth was expected, the miserly 0.2% growth rate continued to dampen expectations of a substantial rebound for the current second quarter. A lower reading on the Institute of Supply Management (ISM) manufacturing survey also indicated a sluggish second quarter growth pace.
If the data were not enough, the Fed’s latest meeting (April 28–29, 2015) concluded with a market-friendly announcement that acknowledged first quarter economic weakness. The Fed viewed first quarter weakness as transitory, but recent economic reports have failed to fully corroborate that notion.
Taken together, the soft economic data and dovish Fed meeting outcome would have normally helped push bond prices higher, but forward-looking markets read between the lines. Fading U.S. dollar strength, better growth in Europe, and the rebound in oil prices point to a reversal of the lower inflation expectations that powered bond strength for most of 2014 and early 2015.
Growth Signals
Inflation expectations—both in Europe and the U.S.—have been volatile, but moving higher [Figure 1]. These market-based measures of inflation expectation are closely monitored by central banks, and the Fed in particular may follow through with a long-expected interest rate increase should inflation expectations continue to rise from here. Consumer inflation expectations as measured by last Friday’s release of the University of Michigan consumer sentiment survey also pointed higher. Together they may incrementally build the Fed’s case to raise interest rates.
Growth signals were not limited to rising inflation expectations as global yield curves continued to steepen. Long-term yields rose more than short-term yields, leading to the steepening move. Yield differentials between 2- and 10-year maturity Treasuries and German government bonds also increased.
A position imbalance likely contributed to bond weakness as the amount of long-term U.S. government bonds held by bond dealers had increased to a multiyear high [Figure 2]. The European bond sell-off created an opportunity for investors to unload positions and reduce interest rate risk. Position extremes, either significant long positions or net short positions, can be contrarian in nature and signal a reversal. Dealers unloading positions may have exacerbated weakness as they back away from market-making activities leading to illiquid trading conditions. Price moves can be intensified under such circumstances.
Late April Shower
Late April weakness led to a poor month of bond performance overall as several bond sectors registered losses [Figure 3]. A reversal, given the strong start to bond performance in 2015, is not entirely surprising and speaks to the more challenging return environment we envision ahead. The last time a growth scare pushed yields higher to a similar degree occurred in September of last year but improvement in Europe gives this latest episode a different feel.
Key Indicators
The 30-year Treasury bond has set the direction for the overall bond market over the past two years and may indicate whether current weakness has run its course. In 2013, the yield on the 30-year Treasury bottomed a few days before yields on other Treasury maturities did the same. If the 30-year Treasury yield sustains a breach above a 2.83% yield, the recent peak and a boundary of the recent yield range, then additional weakness may ensue and higher yields may follow across the maturity spectrum. Similarly, the 10-year German Bund sits near a 0.40% yield, and a break above would mean the current slide continues. Both benchmarks may be the first to usher in more widespread moves across bond markets.
On the economic front, the April employment report, which will be released Friday, May 8, 2015, will be the next key fundamental data point. A disappointing jobs report may question forward-looking growth expectations and bond prices may rebound, while a stronger report may only add fire to the weak sentiment in the bond market. April bond performance is a reminder of the ups and downs investors may expect in what we continue to be a very low return environment in 2015.
Copyright © LPL Financial
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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
Investing in foreign fixed income securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with foreign market settlement. Investing in emerging markets may accentuate these risks.
High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
Mortgage-backed securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
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