By Thomas A. Martin, CFA, Senior Portfolio Manager
They are not Spiderman. They are not horsemen riding through the canyons of Wall Street swinging swords. They are not even a coordinated shadowy cabal of concerned investors. What they are, is a metaphor (that conjures up a great picture in the imagination) for market participants expressing their views by shorting, selling and simply not buying bonds in numbers that are enough to drive yields higher. When pundits (or large sellers) are asked why rates are going up, they sometimes (like now) say it’s because the bond vigilantes are unhappy, and oftentimes they are unhappy with the Fed or the fiscal leadership and the policy course they are on. Sometimes (rarely) the movement in rates can be dramatic enough that it can effect change, but mostly it is simply market forces adjusting prices to market realities. Adjusting to a level of return commensurate with the risks. The adjustment this time around has been reflected in the term premium.
The term premium is the return demanded for taking bond risk after being compensated for inflation and short rates. The term premium had been very low for several years but has moved into positive territory after being mostly negative since 2015. It is still low relative to historical averages. Since the Fed began raising rates, most of the increase had been explained by short term rates and inflation expectations. But the moves of the last couple of months seem to have been more accounted for by the rise of the term premium, the requirement for more return because of other things. Markets (and vigilantes), with central bank interventions somewhat lessened, have incrementally more influence on prices, and are working out what the right yield is on longer dated Treasuries based on their assessment of the information coming in.
That information is rife with many conflicting implications. A heightened level of Treasury supply, Fed net selling, less foreign buyers, the defending of non-dollar currencies, and yes, fiscal irresponsibility and an inability to govern, all put upward pressure on rates. In addition, the uncertainty about the longer-term embedded inflation expectation in rates is by no means settled either (and higher for longer inflation expectations may add to higher for longer rates). Downward pressure on rates is possible from the necessity and efficacy of future potential rate cuts in the event of a deeply deteriorating economy, to say nothing of the reasonable possibility of something else “breaking.”
In the meantime, the employment indicators are still on the stronger side and the consumer is still spending, although there are signs at the margin that spending is slowing, and that consumer financial strength is also fading. The lagged effects of higher rates, higher oil, and tighter lending continue to loom, and the timing of their impact is imminent by historical standards.
What’s an investor to do? Markets are not altruistic, and neither are investors or vigilantes. They assess the risks and opportunities they face and vote by re-positioning their portfolios. We believe the future level of rates is less dependent on the Fed than it has been, and more dependent on other risks that effect the term premium. We have recently reduced our underweight in fixed income as we believe these risks are increasingly priced in, but a persistent level of uncertainty indicates proceeding with caution.
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The opinions and some comments contained herein reflect the judgment of the author, as of the date noted.
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