I am reading “The Strategic Bond Investor,” by Anthony Crescenzi. The copyright is 2010, so the author wrote just after the 2008 financial crisis but missed the Great Recession and recovery and, of course, the 2020 Covid crisis with the Fed’s extreme emergency fed funds cut and buying of all kinds of debt.
Crescenzi is an executive vice president, market strategist and generalist portfolio manager at PIMCO.
As a bond trading professional, Crescenzi uses market indicators that I have never heard of. One of these is the aggregate duration of the bond market. This indicator can be used to analyze the market’s expectation of Federal Reserve interest rate changes, which affect the stock as well as the bond market.
All bonds pay par value if held to maturity. But before maturity, a bond’s value rises if interest rates fall and falls if interest rates rise.
The longer the maturity of a bond, the higher its duration. Duration is a measure of a bond’s price sensitivity to changing interest rates. Longer duration bonds change more than shorter duration bonds when interest rates change.
For every year of duration, a bond will LOSE about 1% in value for each 1% rise in interest rates. This means that a 5-year bond will lose 10% of its value if interest rates rise 2%.
For every year of duration, a bond will GAIN about 1% in value for each 1% drop in interest rates. This means that a 5-year bond will gain 10% of its value if interest rates fall 2%.
https://www.investopedia.com/terms/d/duration.asp
Bond traders are happy when a recession starts because then the Fed will cut the fed funds rate and most other interest rates will follow downward. That makes all their existing bonds worth more. So a “bear” market in stocks (a recession which causes the Fed to cut rates) is often a “bull” market in bonds. Since their long-term bonds will rise more than their short-term bonds, they move to long-term bonds. Then the aggregate duration of their bonds will rise. In 2001-2003 and 2009, when the Fed was cutting rates because of recessions, the aggregate duration of bonds by portfolio managers was higher than normal.
Bond traders hate times like now when the Fed is raising interest rates because the economy is “too hot” and inflation is rising. Since their long-term bonds (high duration) will lose value more than their short-term bonds, they move their portfolios to shorter-term bonds. When the Fed was raising rates from 2004-2006, the aggregate duration of bonds by portfolio managers was lower than normal.
According to Crescenzi, bond investors are very sensitive to changes in the Fed’s policies. The aggregate duration chart he shows clearly exhibits sharp changes in aggregate duration at macro inflection points which would affect both bonds and stocks. Unfortunately, I am not able to find the two companies he mentions (Ried Thunberg and Stone & McCarthy Research Associates smra.com) or any other source of aggregate duration that includes current data.
I would appreciate help finding a chart of aggregate duration.
The closest I came was the S&P U.S. Aggregate Bond Index which is designed to measure the performance of publicly issued U.S. dollar denominated investment-grade debt. The index is part of the S&P Aggregate™ Bond Index family and includes U.S. treasuries, quasi-governments, corporates, taxable municipal bonds, foreign agency, supranational, federal agency, and non-U.S. debentures, covered bonds, and residential mortgage pass-throughs. This index is a gemisch of all kinds of bonds and durations so it doesn’t give the same information as aggregate duration.
It’s clear that bond values are falling, a sign that the bond market believes the Fed will raise interest rates as it said it would.
https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us…
The 2-year Treasury, which historically trends with the fed funds rate, has stabilized at 2.6% over the past few days after a rapid rise. This implies that the bond market thinks that the fed funds rate will be 2.6% in 2 years. The Fed recently raised the fed funds rate to 0.75% and predicted two more 0.5% raises in June and July. The bond market is accepting 1.75% but also expecting further raises of less than 1% in late 2022 and 2023.
The 10 year Treasury has dropped a little (2.787%), which could be noise or it could be a sign that the market thinks the Fed will push the economy into recession.
Since both these rates are far below the Fed’s preferred inflation rate, Personal Consumption Expenditures Price Index = 6.6%, the market seems to be saying that the Fed will be able to get inflation under control by inducing a slowdown while still keeping real yields deeply negative.
This doesn’t make sense to me. They need to raise rates above the inflation rate to quell inflation.
What does make sense is that, at some point, the Fed will push the economy into recession. Then they will feel obliged to cut interest rates to stimulate a recovery. When they begin to cut, bond portfolios should be pushed out to longer durations. Afterward, stocks will recover, though probably not to the current bubble valuations.
Wendy
https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us…
https://stockcharts.com/freecharts/yieldcurve.php
https://stockcharts.com/freecharts/candleglance.html?$IRX,$U…
https://www.bea.gov/data/personal-consumption-expenditures-p…
