It was a decent week for the developed markets with both bond prices and stock prices gaining ground at the same time. For the week the S&P gained +1.2% while the developed EAFE index added +1.0%. Europe was up +0.9% while Japan added +1.2%. Bond prices also advanced given that yields fell once again in the U.S. and most of the developed world. Long-term Treasuries gained +1.2% while intermediate-term bonds added +0.4%. Corporate bonds performed in line with intermediate-term bonds.
The only notable negatives were in the emerging world and commodity space. Indian equities gave back over 4% in the post election hangover while Brazilian stocks dipped -2.8%. Apparently, the fact that Goldman picked Brazil to win the cup was more than offset by news that some world cup tickets in the outlying cities are going for twenty cents of the dollar. Road trip anyone?
We Are Still Talking About the First Quarter
The first quarter is taking on zombie like qualities. For starters it won’t die, or at least we won’t stop talking about it. The catalyst this week was the second estimate of first quarter growth. Specifically:
- As expected GDP contracted in the first quarter. The economy shrank at a -1.0% pace, 0.5% worse than expected (see chart below). The initial estimate for the first quarter had the economy expanding at +0.1%.
- Almost all of the net revision was due to a larger drag from inventory investment, which contributed -1% to the revision. Inventory investment is now estimated to have reduced GDP growth by 1.6% in the quarter.
Interestingly, we saw a similar decline in 2011 when real GDP fell -1.3%, as you can see above. Some ascribe the dip to the weather, others argue that a late Easter made a difference. Both in 2011 and 2014 Easter fell in the third week of April.
Regardless of the reason, the report clearly stunk. So now the question becomes one of trend versus aberration. Is this the start of a trend similar to 2011 where the economy vacillates back and forth for months, or is it truly an aberration quarter?
The economics profession clearly stands in the aberration camp. They see growth of close to +4% in the second quarter followed by 3%+ in the quarters after that. The bond market isn’t so sure. Yields fell to new yearly lows in part due to uncertainty about the economy (more below). Falling gold prices confirm the slowdown/deflationary fears.
We lean towards the more optimistic side, at least for the next few months, because on the same day the GDP revision came out the weekly unemployment claims numbers were released. For the week ended May 24th claims fell 27,000 to 300,000 while the 4-week moving average dipped 11,250 to 311,500 (chart below).
Job growth is proceeding apace, and next Friday’s payrolls report should show growth of 250K to 300K. If so this will mark an important milestone in the post-crisis period – the first time that employment has eclipsed the 2007 peak. The graph below shows the percentage of payrolls lost during post WWII recessions.
What is the Bond Market Telling Us?
If there is one trend this year that has confounded expectations it has been the dip in bond yields. The chart below shows the yield on the 30-year Treasury and the fairly dramatic fall since late 2013.
This week J.P. Morgan took at stab at answering the ‘why’ question:
“U.S. bond yields are low because growth and inflation are low, not just in an absolute sense, but also relative to expectations. (the) current U.S. recovery, now almost five years old, is the weakest since WWII. The economy has only grown 10%, half as much as the average post WWII recovery achieved at five years. Much of this is probably the result of deleveraging and the caution that follows a major financial crisis. There is no clear metric to translate growth into a specific bond yield level. The relation does work in deltas, though. Lower growth pushes bond yields down, and countries with disappointing growth will see yields falling versus countries with better growth.”
They make the point that bond yields rose in 2013 in part because growth expectations for 2014 were being revised higher, as you can see in the lighter line below (J.P. Morgan’s 2014 growth expectations). However, since the beginning of the year growth expectations have fallen from close to 3% to roughly 2.4%. Falling expectations is leading to falling yields.
We’d offer three other factors that could also be at play
As with much today, China could be playing a part. This week The Financial Times noted that China is the largest holder of Treasury securities, but their holdings have not officially grown lately. Holdings peaked at $1.3 trillion last year but have dipped modestly in the latest report. This is curious because the Chinese currency has weakened sharply over the last few months, as you can see below.
China’s currency is heavily managed by the Chinese authorities. For the currency to weaken China would buy U.S. Treasury bonds and sell Rmb. All things equal their Treasury holdings should be ballooning given the currency weakness.
The FT notes that a country can hold their bond positions in a number of places. They could hold them in a U.S. custodian (which would get counted in the official data), or they could park them somewhere else where they might not be directly counted. The FT speculates that Belgium may have the answer. Belgium’s holdings of Treasuries have ballooned from $180 billion to $391 billion, as the green bars below illustrate
If this theory is correct China’s official and non-official Treasury holdings have shot higher in 2014, in part due to China’s desire for a weaker currency. China’s demand has helped push Treasury prices lower
Another theory is that demand out of Europe in particular is pushing yields lower. Relative to the rest of the world, U.S. bond yields are actually pretty attractive. The chart below again shows the yield on the 30-year versus similar bonds in France, Canada, Germany, etc.
European investors are suspected to have shifted into Treasuries the last couple months as speculation of renewed European Central Bank (ECB) action has intensified. The ECB meets on June 5th and they almost certainly will cut interest rates. There is also a decent chance they restart their bank lending scheme. If their policy change is aggressive enough the euro should take a leg lower, or at least that is the hope on the part of European investors (a weaker euro would do a lot to help fight deflation there). So if you put yourself in the position of a German pension manager, would you rather own:
- A Germany bond paying you 2.2% and denominated in a currency likely to weaken, or
- A U.S. bond paying 3.3% denominated in a currency likely to strengthen.
At the margin more managers may have opted for #2 the last few months. They certainly could be wrong about the ECB, but the trade makes sense.
The End of Quantitative Easing (QE)
And finally there is the link with QE. The general thought is that new QE should push bond yields down while the end of a QE program should push bond yields up. Actually, history points to the opposite.
As you can see above, yields increased when QE1, QE2, and QE3 were introduced while yields fell when each QE program was ended. This is for a couple reasons. Introducing QE is viewed as growth positive and risk assets (stocks, commodities, credit) rally at the expense of defensive bonds. Take QE away and there is a bid for bonds as insurance against slower growth and/or renewed deflationary threats.
Frances Coppola who I pulled this chart from, notes:
“When QE stops, whether suddenly or gradually, there is of course no immediate withdrawal of liquidity. But the sudden removal of the INCREASE in liquidity gives the impression of a drought. It’s like someone washing their hands under a running tap instead of in the sink: when that tap is suddenly turned off, or the flow through it is restricted, the washer thinks they have run out of water, even though there is an entire sink full because of the previous flow. This is what is happening in financial markets. The Fed is turning off the QE tap.”
So what is the bottom line? In reality there probably is no one right answer. All could be playing a part. In terms of strategy the question boils down to which of these trends is temporary and could disappear in the next few months?
- The pressure from China is unlikely to end as long as they are battling a slowing economy. Intermediate-term trend.
- While the ECB could very well disappoint, the yield differential in favor of U.S. bonds is likely to persist for some time. Intermediate-term trend
- And QE isn’t coming back this year unless there is a major shock. Intermediate-to-long-term trend.
- So the only factor that hopefully is temporary is the growth backdrop. More robust growth in the second and third quarter would probably put a floor under yields and possibly lead to a modest rise. The trouble is we may not have confidence in this view for another three-to-four months. This probably means investors will continue to chase bond yields lower for a while longer.
What Can’t Sonia Sotomayor Do?
And on a lighter note. A gentleman named 50-cent heaved the ceremonial first pitch at the Mets-Pirates game this week. The Washington Post had a great analysis of the accuracy of his pitch versus some prominent government officials, celebrities, athletes, and fictional characters.
“Was 50 Cent’s ceremonial first pitch at the Mets-Pirates game this week the worst EVER as everyone is saying? Yeah, probably.
That’s according to a highly unscientific study of first pitches we conducted at Wonkblog this morning. We watched a whole bunch of YouTube pitch videos and plotted them, to the best of our ability, across a strike zone diagram, using the tried-and-true “eyeballin’ it” method. You can see the results above.
50 Cent is indeed in a league of his own in terms of his ball’s horizontal distance from home plate. It’s a bit of a toss-up whether his pitch is farther from the plate than Carly Rae Jepsen’s pitch last July, although it’s difficult to compare the two since Jepsen’s pitch hit the ground about halfway there.
Among other entertainers, Justin Bieber and Kim Kardashian both embarrassed themselves far less than 50 Cent. Snoop Dogg pretty much nailed it in 2012. Tara the Hero Cat delivered the ball right over home plate, although she had assistance from her owner.
Fictional and extinct figures (mascots, mostly) also made it closer to the strike zone than 50 Cent. A lack of functional arms didn’t stop T-Rex from outperforming the rapper.
Moving on to politicians and government officials, Sonia Sotomayor and Bill Clinton both made respectable showings. George W. Bush nailed it right down the middle in 2001. But Barack Obama? The less said, the better.”
Where to Follow Gemmer
We are now on Twitter under the moniker @gemmerllc
We have developed a new blog page where we will periodically offer our thoughts on the markets, financial planning topics, and anything else that we feel is interesting and possibly amusing. You can find our blog at the link below.
Have a good weekend…Charles Blankley, CFA