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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly asset allocation report for November 25, 2024. I'm Phil Adler. The decisive November election results did have an impact on the bond market. Confluence advisory director Bill O'Grady joins us today to discuss the post election environment for bonds. Bill, what stands out to you about the way the bond market has responded to the election results?
Bill O'Grady:Well, we have seen rates rise before the election. Financial markets were leaning toward a Trump win, and his policies were seen as expansionary and potentially inflationary. And so after bottoming in mid September, the 10 year yield has risen about 80 basis points. Postelection rates have moved up on average about 10 basis points. So clearly, the bulk of the rise was driven by expectations of a Trump win.
Bill O'Grady:The most concerning outcome and the one we thought had a higher probability was a disputed or hung election. That could have led to widespread unrest and probably would have led to a flight to safety trade that would have benefited bonds, but the actual results were beyond dispute and thus yields remain elevated.
Phil Adler:Now since the election, money seems to be flowing into fixed income assets, and and a measure of credit risk has been falling. Why?
Bill O'Grady:Well, the credit risk has been low since the pandemic. The expansion of the Fed's balance sheet and the avoidance of recession has led to narrowing credit spreads. Another factor has been expansionary fiscal policy. To a great extent, the widening fiscal deficit offset tighter monetary policy and thus facilitated narrowing credit spreads.
Phil Adler:And the yield curve seems to be flattening again. Is this a serious concern?
Bill O'Grady:Using the 210 t note spread, the curve uninverted in September. It flattened a bit recently, but it does remain positive. It is a modest concern in that the recent flattening does seem to reflect reduced expectations of fed easing. Although there are still some recession indicators signaling a downturn, for the most part, we don't expect one to develop barring an unusual event, such as an oil price spike due to geopolitical event, a major war, or something of that magnitude.
Phil Adler:Bill, you included a chart in in this week's report showing that yields at the long end of the curve are running below fair value. How did you arrive at this conclusion?
Bill O'Grady:Well, we developed this yield curve model back in our days at AG Edwards and have adjusted it over the years at confluence. Its primary independent variables are fed funds, the 15 year average of inflation, and the 5 year standard deviation of inflation. These variables account for over 90% of the level of yields. From there, we had comparable yields from Germany and Japan, WTI oil prices, the fiscal deficit scaled to GDP, the in dollar exchange rate, and a binary variable for whether or not we have a unified government. The model's output suggests a fair value yield of 4.57.
Bill O'Grady:Note that we use monthly average yields, not current yields, so we are seeing rates a bit below fair value.
Phil Adler:What does this portend about the future direction of yields?
Bill O'Grady:Well, it suggests to us at a minimum that there isn't a lot of value in long duration treasuries unless you're worried about a flight to safety event. Yields can diverge from fair value, but in general, the model would suggest higher future yields.
Phil Adler:Now you've identified a number of factors which may determine whether yields will in fact continue to rise, and one is a unified government with Republicans controlling the house, the senate, and the presidency. How could government unity affect yields?
Bill O'Grady:Well, generally, a unified government adds about 30 basis points to the fair value yield. In general, a unified government has a better chance of passing legislation than a divided one, and so the bond market prices in risk of stronger growth and potentially higher inflation.
Phil Adler:Another unknown is whether the Fed will cut rates beyond the 50 basis points that the market had been expecting before, I guess, some recent repositioning. Which way do you think the Fed is leaning?
Bill O'Grady:Although they have been signaling further rate cuts, inflation isn't cooperating. It will be difficult for the Fed to lower rates a whole lot further. We have a number of models that try to establish the proper level for the policy rate. Based on our Phillips curve model, the Fed should frankly stop now. We have another set of models based off the Taylor rule, which would argue for Fed funds between 4 to 4 and a half percent.
Bill O'Grady:So I'm expecting 1 25 basis point rate cut, but then likely a pause.
Phil Adler:And what effect would a pause in rate cutting have on long term yields?
Bill O'Grady:Well, on its face, it would lead to higher yields. However, if the market concludes that the Fed is leaning against inflation, the long end would actually prefer that position, and it could lead to lower yields.
Phil Adler:Is it likely, Bill, that the Fed might do what it has done at times in the past and adjust its borrowing scheme to help keep long term rates in check?
Bill O'Grady:I don't think so. The Fed is trying to maintain its independence. It would probably want to avoid the appearance of caving to the bond market. Obviously, if rising yields were to cause a problem for the economy, it would react. For example, when Silicon Valley Bank failed, the Fed did move to support the market.
Bill O'Grady:But at this point, I think they will most likely let yields rise. I would say this. The clear test will be is if the 10 year yield rises above 5%. That was the last time the Fed intervened to bring yields down. If they don't react, then the scenario I just laid out would be more likely.
Phil Adler:And what strategy do you advise for bond investors?
Bill O'Grady:Well, we have been encouraging investors to reduce duration. Although in our last rebalance, we added a zero coupon bond position just in case we had a hung election. So we've actually expanded duration but for a specific outcome. In the wake of the election, we'll have to revisit that position in January.
Phil Adler:Are longer long term bond yields necessarily a wet blanket for stocks?
Bill O'Grady:In general, higher longer term rates tend to weigh on the multiple. But it doesn't look like we're at a point quite yet where stocks have an issue with longer term interest rates.
Phil Adler:Bill, I'd like to conclude today with a question about mortgage rates, which have not come down since the election, at least not at the time of our recording, even as the fed cut short term rates. Do you think should home buyers simply get used to rates above 6% for a 30 year mortgage?
Bill O'Grady:Well, Phil, if there's anything I worry about, it's the housing market. History shows that periods of falling nominal home prices lead to very bad outcomes. We saw that occur before the great depression and the great financial crisis. Persistently high mortgage rates are not consistent with high home prices. We have avoided a problem because homeowners have mostly stayed put rather than lose their low mortgage rate.
Bill O'Grady:The best long term solution is increased new home building, which can be priced for the higher rate and steady existing home prices for a few years to allow wages to catch up with a higher mortgage payment. So, yes, I don't expect much relief on the mortgage front.
Phil Adler:Thank you, Bill. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.