What Two Bond Market Indicators Are Telling Investors at Midyear

Barry Johnson from TX posted over 2 years ago:

Charles, thanks for your helpful insights on the majority of factors that worry AAII members while they are cursed to “live in interesting times” – inflation (40%) and interest rates (21%). In his Beauty Contest Theory (in his 1936 General Theory), Lord J.M. Keynes demonstrated the value of being able to think beyond 1st level factors (like the ones reported in the recent AAII survey reported above) and to anticipate the impacts of 2nd and 3rd and deeper level factors when trying to predict the overall most likely final consensus from any survey. By surveying for the “most important factors,” the AAII survey neglected to collect AAII member assessments of the 2nd, 3rd, and other upstream factors that produce the “most important” factors. In your article, your analysis called out two examples of 2nd level factors. #1 the impact of “bond market participants” on breakeven interest rates, and #2 the impacts of the FOMC (monetary policy ) decision-making on yield curves. Given these two levels of analysis, the question then becomes what are the 3rd level factors influencing the 2nd level factors? What do “bond market participants” and FOMC members look at to make their guestimates. This requires investors to estimate what factors influence both interest rates and yield curves. These questions would be interesting topics for future surveys or maybe for an article. My point is that is important that investor look beyond level 1 (“headline”) factors which are always the outcomes of 2nd, 3rd, and other factors at deeper levels. If you don’t understand what is driving the 1st level headline factors, you will not know how to diversify your portfolio to minimize the impacts of “market risks” on portfolio returns. As you article suggest, equities will probably produce higher returns that bonds, but I have seen several articles suggesting that since the 2000-2001 dotcom “bubble” and the 2008-2009 “Great Recession” the expected return of equites will NOT be as high as historical rates have been due to deeper factors like the ones I am suggesting lurk in the depths. Persistent inflation and lingering yield curves may be early warning signals of a change in historical market dynamics. Cue the music from “Jaws.”

John L from NJ posted over 2 years ago:

Maybe both of these indicators tell us nothing! Break even rates tell us the market expectations for inflation; but how accurate has this "forecast" been in the past? How useful were these expectations just before inflation took off in 2021 and 2022? The difference in long and short interest rates in the past were a good proxy for bank's lending margins as they borrow short and lend long. When short rates are higher than long rates, banks lending margins are negative leading banks to reduce lending. Companies that relied on bank loans for expansion and perhaps ongoing operations (small value companies) would be starved for funds and start cutting back. Ultimately these cut backs would leading to lay offs and a recession. But that was when the Federal Reserve was targeting over night lending rates and would remove reserves from the banking system in order to increase short term rates. After 2008, the Federal Reserve changed to an abundant reserve policy and began paying banks interest on reserves held at the Federal Reserve. Now banks are not starved for funds when the short term rate is raised by the Federal Reserve. Instead they receive higher interest payments on their reserves at the Federal Reserve. Their margin now is essentially the difference between what they pay for deposits (my interest bearing checking accounts are still paying 0.01%) and the long term rate they receive on loans to business and consumers. So maybe now the yield curve doesn't describe bank's gross margin and is no longer a useful indicator of up coming recessions.

Patti R from AZ posted over 2 years ago:

To Barry's point: "Equities will probably produce higher returns that bonds, but I have seen several articles suggesting that since the 2000-2001 dotcom “bubble” and the 2008-2009 “Great Recession” the expected return of equities will NOT be as high as historical rates have been..." Then Barry comments on a change in historical market dynamics. Getting more general than interest rates into other market topics: It drives me crazy when AAII publishes articles from authors that use stock market data going back to 1926. Authors draw conclusions on various topics using this data. Just because the data is available doesn't mean it's still relevant and should be used. I believe that the markets are different today than they were 50 - 100 years ago. I think conclusions would be more relevant if they were based on more current data. Is that 50 years? Is that 25 years? I don't know. I think Barry calls out the importance of the effect of recent market dynamics to be able to draw conclusions relevant to the future.