It’s not often we get to analogize between the bond market and baseball in our quarterly commentary, but given that the Pittsburgh Pirates recently made the playoffs for the first time since 1992, it seems apropos. Over the last several years, with the US economy unable to gain traction, the Federal Reserve has lobbed over $3 trillion of fresh cash into the banking system via so-called Quantitative Easing (QE). Delivered in hopes of generating faster growth, QE hasn’t done much for the real economy, but it’s been an absolute home run for stock and bond prices.
Things began to change in May, however, when Fed Chairman Ben Bernanke hinted that there might be an end to the bond buying. He reemphasized that possibility in July, and bond prices responded accordingly. Between Memorial Day and Labor Day, 10-Year U.S. Treasury prices fell by approximately 11% in anticipation that the Fed would deliver a “tapering” of bond purchases at its September meeting. Come September 18th, however, Ben turned on dime and picked the entire bond market off second base. Instead of tapering, the Fed announced a “steady as she goes” policy dependent upon future economic data. Interest rates fell, retracing a portion of their summer rise. Instead of rounding third and getting ready to touch home in hopes of a “normalization” of interest rates, bond investors skulked back to the dugout.
The market had fully discounted a reduction in Fed bond purchases, and was caught off guard by the decision. The 10-year Treasury has since recaptured some of its summer losses, but as the following graph shows, there is still a long way to go. With a current yield of about 2.61%, the 10-year T-bond is still nearly a full percentage point higher in yield than it was in May. The entire Treasury yield curve is also higher than a quarter ago, as the market believes there still could be a reduction in Fed bond purchases by year end.
In addition to shifts in the monetary mix during the quarter, the lack of a coherent fiscal policy in Washington DC contributed to the rally in long term bond prices. A “flight to quality” bid was evident in late September, as equities sold off and investors fled to the safety of Treasuries in anticipation of the debt ceiling fight. Corporate and municipal bonds were also able to recoup some of the June quarter’s losses, and actually had their best quarter of the year. Worldwide, corporate debt instruments returned 1.4% last quarter, reducing the previous quarter’s 2.2% decline to a net loss of only 0.8%. The month of September also saw record new corporate issuance of $148 billion, which was a 17% increase from the same month a year ago. This total included $49 billion of various maturities issued by Verizon Communications in a deal that was three times oversubscribed. Verizon rushed to get the massive deal done ahead of the Fed meeting on September 18, as they obviously expected a tapering. Surprise!
The big swings in interest rates in recent months have the entire investment community in a general state of nervousness. At Fort Pitt Capital, we’ve limited our recent bond purchases to shorter dated corporates, municipals, Certificates of Deposit and agencies. Shorter maturities allow us to stay invested at rates higher than is available on overnight money, but without the duration risk that goes with longer-dated securities. With the Fed almost guaranteeing they won’t raise overnight interest rates before 2015, investing in shorter, high-grade instruments allows us to add yield while we wait for fiscal and monetary policies to sort themselves out. As we witnessed in May, buying into the tail end of a rally can be painful when the market decides to turn. As the fog clears in coming months, we expect the yield curve to steepen as long term interest rates rise again in anticipation of reduced Fed bond buying. We don’t believe this is the time to extend duration, and we’re watching Bernanke very closely Getting picked off is no fun!