FLGB - What Bond Yields Are Telling Us About The Economy And Markets
2023-10-05 03:27:00 ET
Summary
- What to expect in the final quarter of the year.
- Why the Fed may not be done hiking rates.
- Why bond yields are grinding higher.
Bond yields are rising as investors focus on the state of the U.S. economy and interest rates. Michael Craig, Head of Asset Allocation at TD Asset Management, speaks with Greg Bonnell about what he sees in the current investing environment and what to expect this quarter.
Transcript
Greg Bonnell: We're officially trading in the month of October. Also means it's the last quarter of 2023. Now, markets so far defied expectations, and so has the economy.
Now we've got rising bond yields, markets under pressure. Michael Craig, head of asset allocation, here to talk about all of it with us. These are interesting days, as we enter now the last three months of the trading year.
Michael Craig: "Excruciating" would probably be more apt. But yes, it hasn't been a fun year, for sure.
Greg Bonnell: Well, let's talk about the dynamics here. Because it's been a much different picture. And I think a lot of things have defied expectations, as we said, whether it's labor, whether it's consumer spending. You've got bond yields moving aggressively higher in the last several weeks, really. I mean, what is taking shape in the market right now, and how do we make sense of it?
Michael Craig: Right. So the bond market really started rolling over since August, surprisingly. I think most market participants are quite taken aback by the move. Many got long rates at lower yields, and now are feeling that.
I would say that, as we think where we go from here, the easier part of inflation reduction has happened. So we've seen a decline in goods prices. That's happened. I think we're on the precipice of seeing a decline in rents.
But what I think we should think about going forward is, that the last bit of inflation reduction back to those targeted ranges is going to be challenging. And the bond market's basically saying it's going to need to push the economy into some type of recession to get there.
There was a bit of a soft landing narrative, I think, circling the market, which we never really believed in. And it really was trying to describe the very strong US equity performance in the first half of the year I think that narrative now is past.
And really now, I think it becomes how severe a recession we're going to need to see to create the demand destruction to get inflation back to target, right? And so I think that's what the bond market is telling you, is that it's going to really restrict financial conditions to create that demand destruction. But just the speed with which it's doing it is just quite remarkable.
Greg Bonnell: Quite remarkable. What does it actually mean for the central banks as well? I mean, the bond market is sort of making its voice heard. We still have to hear from central banks before the end of the year with rate decisions.
Trying to figure out the coin toss, right? Are they done? Are they going to go again? How long are they going to stay high for? What does this environment do to a central bank's thinking?
Michael Craig: I think that for the central banks, because inflation kind of got away from them, and there is a credibility issue, they were going to have to really keep restrictive conditions in place until they have very, very tangible evidence that not only is inflation back to range, but it's not going to rebound. The lesson which many people point to in the 1970s was, inflation came off, and job markets started to crack. At the time, there was more focus on jobs than inflation, so you get easing quite quickly. And the next thing you knew, within a year's time, inflation is back to 5%.
And so I think they are going to wait on this to make sure that they believe that inflation is within that range, and it's not going to accelerate if they ease, which really gets you back to this kind of "higher for longer." It's been a tricky one to call this year. The markets are not expecting much more.
We might get another hike in Canada, maybe half a chance of one hike in the US. That could certainly change if we get inflation going higher, which I don't believe is going to happen. So the easier answer is, I think we're probably done for hikes.
But the more challenging one is, how long are we going to stay restrictive? And that is the million-dollar question. The way I see it is, you're going to see a precipitous fall in activity. And timing that is a mug's game, but when it does, you'll see a pretty rapid decline in interest rates. But that is probably a late '24 story but with a lot of uncertainty.
Greg Bonnell: Let's talk about that and, if we do get this hard landing, what the market looks like. I mean, obviously, we would expect an acceleration in the unemployment rate on that side of the economic data. We expect to pull back in our economic output. What would the markets look throughout a period like that?
Michael Craig: Markets are typically forward-looking indicators. I think the markets are actually starting to price that outcome right now. And so by the time the real economy really feels that pain, the markets will probably be bottoming. And that will be the point where returns, I think, going forward, will be higher.
But this move right now -- I mean, the stock market has finally gotten the message from the bond market that, hey, dude, tighter money is here, and it's hard to justify your valuations when money is trading at 5% or 6%. You can get basically great rates on cash products for that.
So you really need a higher risk premium in the stock market, and that's just not there. So I think the stock market is starting to realize. It's starting to catch up to where the bond market is at.
We're probably entering the peak pain of what has been a two-year malaise. Stocks are flat or actually down on a two-year window now. And I think this is the end of this mini-bear market, if you will, which has been the last two years. It's the beginning of the end of that market. And I would expect a couple of quarters of maybe challenging conditions before you have much more upside in stocks.
Greg Bonnell: Is the attractiveness of those cash products you mentioned part of the problem too for equities? Say you've got an equity that pays a yield of 4.5% or 5%, in terms of the dividend, and then you have a cash product that's paying 4.5% or 5%. Are they fighting each other?
Michael Craig: Well, I think, investing, you've got to always think of the time horizon. Sure you can get 6% for one year, but in one year's time, there's no guarantee you get another 6%. So I think that people flock to cash because they see the current price is high, but often -- if you need the money in the next year, it makes total sense.
But if you're moving long-term investments over, and you're saying, I just can't be bothered right now, I just want to be out -- over long periods of time, if you look at any type of index chart, these periods of chaos don't look like much. If you are a long-term investor, you should be looking to accumulate in these types of periods. It's just, over the next six months or so, it's challenging.
So I always say, with cash, you always want cash. You always want to have some cash on hand. You might need it. You might have expenses.
But that should be a very small part of your overall investment portfolio. But nevertheless, we're seeing that move to cash, because people are making that kind of quick judgment now and saying, well, I'm going to try to lock this in. It's only going to be there for so long.
Greg Bonnell: Before we finish this discussion, I did want to ask you -- in times like these, when you see bond yields moving aggressively higher, when you see all this kind of activity, the phrase "bond vigilante" starts coming up again in the press and in the commentary. Is this the work of bond vigilantes?
Michael Craig: I think we're trying to take another period of history and slap it onto this one. Now, in all fairness, Western democracies are spending too much money. And in all fairness, we will need to make some decisions about investment.
And we have now moved away from an era of free money. So you have to make decisions. And if those decisions are not thoughtful, there is a price to be paid.
In the fall of last year, the UK is a prime example of what a bond vigilante environment looks like. They came, they slashed tax -- unfunded tax cuts. And the bond market just basically blew up. They had like a pension crisis. Over the five weeks, bond yields just exploded higher.
If governments haven't got the message yet, they will soon. If they come out with an announcement on spending that's going to rapidly reduce the deficits, you're going to see a move in the bond market. Whereas in previous periods, because we had so much excess slack, you didn't see it.
So I think there's a little bit of that at play right now. The US certainly is running unsustainable fiscal policy. You see where this is going. It's going into a dumpster fire if they don't correct that over the next 10 years.
It's just, there hasn't been the political courage yet, because there hasn't been enough pain. So I think there is a part of that story to be held. Right now, I think this is more of just a buyer's strike, and there's so much volatility in the market, people are just holding back. But this is a term that I don't think is going to disappear anytime soon. Because we are in a period of very restrictive money, and governments are still running excessive deficits.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
What Bond Yields Are Telling Us About The Economy And Markets