What Is Going On in the Bond Market?

By Dean Barber

April 7, 2022

What Is Going On in the Bond Market?

Key Points – What Is Going On in the Bond Market?

  • What is an Inverted Yield Curve?
  • A Shake Up in the Bond Market
  • Strategies for Buying Bonds in Today’s Market
  • Market Reactions to Inverted Yield Curves

Back in the Saddle

Dean Barber: Thanks so much for joining us here on America’s Wealth Management Show. I’m your host, Dean Barber, along with Bud Kasper. Hey, Bud. What’s going on?

Bud Kasper: Hey, welcome back, Dean.

Dean Barber: Hey, good to be here. It’s not as good as where I was, but it is good to be here.

Bud Kasper: Well, we missed you.

Dean Barber: Well, thank you. Thank you. I love doing this show, so it is good to be back.

Bud Kasper: Yeah, no doubt. And we got a lot on our plates.

Dean Barber: Well, something happened as I was sailing around the Virgin Islands with my wife and another couple, and it’s in the financial markets. We saw something happen that we haven’t seen since late 2019, and that is a yield curve inversion. I think it deserves some discussion on what a yield curve inversion means? What does it mean to the economy?

What is an Inverted Yield Curve?

Dean Barber: To set the stage here, Bud, I want to talk about how an inverted yield curve is essentially when the yields on the shorter-term treasuries are higher than the yields on the longer-term treasury. The most used is the two-year treasury versus the 10-year treasury. If you chart the yield curve going back into the 1970s, and every single time since the 70s that the yield curve has inverted, a recession has followed. Now, it’s not that a recession follows immediately. There have been times when it’s up to two years before the recession, and the yield curve is no longer inverted by the time the recession comes.

It means that the longer-term outlook for the economy is not as solid as the short-term outlook for the economy. It’s a deceleration of growth in the economy, potentially leading to a reversal and a shrinkage of our GDP. I think what’s exacerbating that is the super high inflation along with a Fed that got behind the eight ball and is now saying, “okay, we’re going to have to get more aggressive on the raising of interest rates,” at a time when the market itself is saying, “you know what? This economy’s going to cool off on its own. I don’t think the Fed needs to be that aggressive. If they get too aggressive, that will push us into a recession.”

The Federal Reserve and Interest Rates

Bud Kasper: Exactly right. I wouldn’t want to be on the Federal Open Market Committee that makes these decisions on whether to raise or decrease interest rates. They did the appropriate thing during COVID. So if you go back to 2020, when they came in and introduced the stimulus program, it’s what we needed at the time, because the pandemic was impacting the economy. And so as that worked, and then it carried forward into last year, we saw the benefits of what the Federal Reserve was doing at that time, but it is a tight rope, folks. And what I mean by that is they don’t know exactly when they need to pull back so that they don’t overheat the economy.

So what happens is, is the bond market tells you if it’s overheating. If you ever listen to any of the financial shows on television, you’ll hear them talk about the twos and 10s. You can also look at the fives and 30s, which is another way of addressing this. But let’s stay with the standard fair of twos and 10s, because an inverted yield curve is one of the most reliable leading indicators of an impending recession.

We don’t know how deep the recession might be, but we know this: the Federal Reserve raised the Fed Fund rate only a quarter a point at their last meeting of the FOMC. We also know that they’re coming up on another one. And the talk is that we may have as many as three half a percent increases or six quarter-percent increases before the end of the year. And by the way, if we do that, they won’t all be on the meetings of the FOMC.

Dean Barber: Right. There could be some between meetings.

Bud Kasper: Right.

A Shakeup in the Bond Market

Dean Barber: So I think the issue here, Bud, is that we see a shakeup, a massive shakeup in the bond market. Now, you and I talked about this before I went on my vacation, and we talked about alternatives to the bond market. One of the things that you and I discussed before we started the program today was the shorter-term yields are now high enough on treasuries that you could create a short-term treasury ladder and do far better than what you’re going to do in a money market account.

And obviously, you’re going to have, what we would say, every three to six months, you’re going to have the liquidity to roll into another shorter-term treasury, but that could be one way to play this. And there are other alternatives, and we’d be happy to talk to you about those alternatives and how they could apply to your portfolio.

Bud, I’ll say this, I haven’t seen this much uncertainty in the overall markets and economy since 2008. There are just so many different things that are happening. People have to step back and say, all right, what does all this mean to me? It’s critical for those planning on retiring in the next five years or those already retired. If you don’t take the proper steps to protect yourself, this could be a game-changer in a bad way for your retirement.

A Potentially Scary Stagflation Situation

We could have stagflation, Bud, which is really a scary, scary situation. In the late ‘70s, high inflation and a stagnating economy did not bode well for the stock market or bond market.

Bud Kasper: Right.

Dean Barber: You need to ensure that you’re getting this right. Check out the article we just released on the inverted yield curve and download a copy of the Retirement Plan Checklist. Find out where you stand today.

So Bud, let’s go through some timeframes here on this. And you got some other data that you want to share with our listeners, but I think people must pay attention. Now is not a time to bury your head in the sand and hope that everything will be okay.

Bud Kasper: Most certainly, we have to pay attention to this. We are going to see an adverse reaction associated with the bond market for sure. And the question, though, is, and I’m hopeful, I am confident, and I think there’s a long shot on this, that the Federal Reserve will be able to create a soft landing. Now, if that is possible, and we live through a little bit of the pain that we’re experiencing right now, we have to go back to the fundamentals, and the fundamentals in the stock market are still strong.

We’re about to enter into earnings season when earnings come in, and we pay attention to those almost daily. If we see positive numbers, which I’m pretty confident will happen, that will help calm the waters. Then we don’t have to bail on stocks because of damage from the action of the Federal Reserve. But I’m hoping that this will be a softer landing. So by the end of the year, I’m hoping the market will be up.

Signs Point to Economic Deceleration

Dean Barber: I think that’s a possibility. And if we step away from interest rates and we step away from the market look at the overall economy, the signals are telling us right now that we are going into a slowing growth period. So, in other words, we just came out of an accelerated growth period coming off the heels of COVID-19. And we’re now seeing a deceleration in the rate of growth.

And we know that slowdown in the rate of change continues through 2023. From an economic perspective, the signals that we look at don’t say recession before the end of 2023, but they do say a deceleration of growth. Now that deceleration could be enough later this year, the Fed doesn’t have to do as much as think, Bud. But all that remains to be unseen and all that provides a high degree of uncertainty, and the stock market hates uncertainty.

Bud Kasper: Yeah. So if you don’t have a plan, you’re probably going to be a sorry investor from that perspective. Let me give you a little bit of history here. Since 1955, equities have peaked six times after the start of an inversion. Peaked, okay? And the economy has fallen into a recession within seven to 24 months. So that’s a pretty big spread there-

Dean Barber: A big span. A big span.

Strategies for Buying Bonds in Today’s Market

Bud Kasper: In terms of what would happen. But as these interest rates rise, Dean, I think you’ll start seeing people say, “I’m going to buy that interest rate on that 30 year. I’m going to buy that 20-year bond.” Why?

A, it’s paying me to B in it, and C, the Federal Reserve is more than likely to start to drop the interest rates.

And when that happens, that investment will have a capital gain on top of the interest income. So if this sounds a little confusing or complicated, it is. Still, it’s manageable as long as we understand what history has represented to us and how we can intelligently continue to move returns forward without a great deal of risk.

Using Float Notes and Bond Ladders for Fixed Income

Dean Barber: There’s a lot of financial institutions out there today, Bud, that are issuing what’s called a fixed to float note. I’m going to give an example of a client we have a bond ladder for. And the bond ladder can give you a known outcome, almost like a CD, how much you purchased the bond for, you know what the yield’s going to be and you know, I mean, it’s going to mature. And so you can calculate your yield to maturity. The fixed to float notes out there, Bud, my favorite ones are in the five-year range. And the ones in the five-year range right now are yielding around 5%. You can get some at 5.25%. And what happens at the end of those five years? The rate on the bond will float and be the five-year treasury yield plus 3%.

So when we did this one for a client last week, we were able to buy at par.

Bud Kasper: A thousand dollars for a thousand dollars.

Dean Barber: Right. And we would get a 5% yield maturity 2027.

And then 3% on top of the five-year treasury at that time. The five-year treasury today is about 2.75%. So, let’s say the five-year treasury stays exactly where it’s at 5.75%. And that is if the financial institution that issues that fixed to float note decide that they want to pay that 5.75%, or they call that thing back in, and we’re going to give you back the money that you put into it. What I’m saying is, I don’t want people to think that all bonds are bad. Because there are ways to do some decent things with that fixed income part of your portfolio. And you don’t have to be scared of it.

Looking at the National Debt

Bud Kasper: No, I agree with that. But let me go a little bit deeper and look at the country’s indebtedness. So approximately $33 trillion worth of debt, we have $9 trillion on the Federal Reserve’s balance sheet. Remember what we talked about in prior shows back in December? They cut the $120 billion worth of bond buying back to 60 billion as they move forward.

Dean Barber: Per month.

Bud Kasper: Per month, right? But my point with all that is, and I do get this from clients occasionally, is the dollar going to continue to be strong? Will it be the better currency, if you will, especially with all this talk about Bitcoin and all this other kind of stuff? My reply is, “absolutely.” Foreigners are still pouring money into the treasury market because it’s the United States. We have the ability for us to carry the highest credit out there versus the other countries that represent a bond market as well.

U.S. Bond Market compared to International Bonds

Dean Barber: Well, let’s reflect on that a little bit, Bud. So in UK, the UK 10 year equivalent of our treasury is 1.75%. Our one year is 1.77%.

Bud Kasper: Perfect.

Dean Barber: Okay? So there’s an example of why. Germany, their 10-year is 0.682%. Italy, they’re 10-year is closer to ours at 2.374%. But you go on France, their 10-year is at 1.226%. Japan, their 10-year is at 0.239%. So why do you think there’s still foreign interest in our treasuries, Bud?

Bud Kasper: Sure.

Dean Barber: There will be interest in our treasuries whenever our one year is yielding higher than most countries’ 10 years.

Bud Kasper: Yeah. Now we do have to understand currency translations with that as well. In other words, what’s the yen worth versus the dollar, but the United States is still the go-to place for safe money.

Taking Time to Assess the Big Picture

Dean Barber: Right. We’re going to have uncertainty. Fixed income, especially the traditional bonds, like the bond aggregate BND, SPAB, or AGG, the tickers on some ETFs that mirror the bond market aggregate, in my opinion, right now, that’s not the place to be. And you need to start trimming positions in those types of things, and you need to be looking for alternatives.

And the other thing that I think is critical right now, Bud, is that I think people should be stepping back a little bit and saying, okay, if you were participating in the markets in 2020 and 2021, you likely are way ahead of where you were in January of 2020. Let’s step back and say, all right, re-look at my overall financial plan. Let’s look at the most conservative portfolio that I could position myself in today to do all the things I want and potentially mitigate some risk to be cautious and capture some gains from the last couple of years.

The Guided Retirement System™

Bud Kasper: The plan score, in other words, the probability of success, fluctuates with every given element associated with your financial life.

Dean Barber: Right.

Bud Kasper: As this happens, though, we get to go back and rescore it to see if we’re still on track for the success that people are hoping for. You need to have that experience, folks.

Dean Barber: Right. It’s like the GPS in your car when there’s construction, or you need to stop to use the restroom. That’s what the financial planning tool that we have, our Guided Retirement System™ does. It tells you where you are at and what’s the safest route to get where you want to be.

What Do Dolphins and the Bond Market Have in Common?

Dean Barber: So, my wife, myself, and another couple were on a catamaran in the Virgin Islands, and a group of dolphins began swimming beside us. There were about 20 of them, and they were swimming inverted.

Bud Kasper: Get out. Do they do that?

Dean Barber: Yeah, they do. 

Bud Kasper: Do they flip on their backs?

Dean Barber: Yeah, it was pretty cool. I think that happened the same day that the yield curve inverted.

Bud Kasper: Yeah. So that was flipper and his family that was with you.

Dean Barber: He was giving a warning, right? “The yield curve is inverting!”

Bud Kasper: Yeah. Turn back, turn back.

What Does the FOMC Do?

Folks, you need to understand that the FOMC, the Federal Open Market Committee, represents presidents of the Federal Reserve, but not all presidents have voting powers. They have a select group that then rotates in and out with that. 

But that doesn’t mean that they are not there making commentary associated with the strategy’s going forward. And just today, or just this week, we began hearing that more of the Fed presidents are coming forward and talking about this inverted yield curve that you and I are talking about today, Dean. 

Time to Speed Things Up (Raising Rates)

So, they’re suggesting that we need to start to raise rates even more for the simple reason of trying to get ahead of the inflationary issues from an inverted yield curve. 

Bud Kasper: So I know sometimes this subject seems a little stressed from the position of our listeners, but it is important for you to understand this. This isn’t something that you panic over. It’s something that you understand and realize how to maneuver carefully during this timeframe to keep your principal secure and still look for growth opportunities.

Dean Barber: So the people on the FOMC you’re talking about that were warning about this were the Philadelphia Fed President, Patrick Harker, and it was Governor Lael Brainard, and San Francisco Fed President, Mary Daly. All expressed concern over inflation and are essentially saying we have to do something sooner rather than later to combat the high inflation.

Will We See a Larger Rise in Rates Soon?

Bud Kasper: Right. For the last month, James Bullard, Governor for President of the Federal Reserve in St. Louis, and Esther George, President of the Federal Reserve here in Kansas City, have been saying, “Raise a half, raise a half.” We didn’t get a half. We got a quarter, but we’re getting a half soon.

Dean Barber: Well, and remember, for those of you that don’t know this, when the Fed starts to talk about raising rates, they control the overnight lending rate, the bank-to-bank rates. 

So it’s the ultra-short-term rates. They do not control the longer-term rates. And this is where the inversion in the yield curve can come from. Because the 10-year treasury yields lower than the two-year treasury, the bond market is signaling slower growth and the potential for a recession. 

Historical Recessions Following Yield Curve Inversion

Each time the yield curve has inverted since the late ’70s, a recession has followed anywhere from a six to 20-months period.

Dean Barber: That’s a long span there, and not all recessions have been deep, and it doesn’t mean that the market falls apart immediately. But there are a lot of dynamics at play today that weren’t there. 

I would say when the yield curve inverted in June of 1998. Remember the yield curve inverting in June of 1998? That was about the same time Alan Greenspan started talking about irrational exuberance in the markets. We saw another 25 to 30% increase from June of ’98 through to the end of 1999, early 2000, depending upon what indices. It doesn’t mean that things are falling apart immediately. It means it’s time to step back and reassess what you own and understand during recessionary times how does what you own typically react.

Buy and Hold Isn’t Necessarily the Best Strategy

Bud Kasper: This is a situation as well, Dean, that buy and hold isn’t probably the best strategy because we have to be able to adjust to the various economic conditions that occur. It’s our responsibility to our clients to have a thorough full disclosure about what possibilities, what probabilities are out there, and our plan.

Dean Barber: Right. Because our job is to get people to retirement and then through retirement. There’s a total paradigm shift when you go from working into retirement. Many of the rules you were following during your working years don’t apply. And in fact, the rules are drastically changed during those retirement years. 

Again, our role is to get people to retirement and through retirement to live their one best financial life and do the things that are important to them. It requires far more than just a buy and hold strategy, like you said, Bud.

Significant Bond Market Exposure Can Be Difficult Right Now

Bud Kasper: Yeah. It’s a difficult situation for people with significant bond market exposure. So when I look at, especially some of our larger clients in higher tax brackets, and we’re using municipal bonds for the tax-free income, it doesn’t matter. It will react the same way as if you own a treasury bond. So at issue with that is you have the advantage of federally tax-free income instead of federally taxable income. 

But I don’t believe that’s not going to hold up to the degree that the principal value of those bonds will still be under pressure. No different than they will be for treasuries as well. If you can forecast this, I certainly want to hear it. We finally have rising interest rates where these longer maturing bonds will be very attractive in terms of what the yields will appear. Is that the time to go in and make some cash off the line, go in and buy and secure some higher interest rates for future income?

Dean Barber: There’s no question that if the Fed continues to raise rates, we continue to see rates rise across the board, the 10-year treasury forecast is accurate, we go into a slowing growth economy, and the Fed overdoes it – we go into a recession. 

At that time, the bond market will be super attractive again because what’s going to happen is interest rates will begin to drop. When they do, they generally fall pretty fast, so that’s the point where you can get capital gains and the interest on those bonds. There’ll be a time when the traditional bond market aggregate type will make sense again. But right now, it’s time to step a little bit to the side and do some things a bit differently, as we talked about earlier.

Market Reactions to Inverted Yield Curves

Dean Barber: Bud, we’ve beat up the yield curve discussion here. But I want to note again that every time the yield curve inverted since the late seventies, there has been a recession that followed within six to 20 months.

Every recession was different. They were all triggered by different things. But in most cases, there was still a decent run-up in the stock market after the yield curve inverted. So now volatility tends to rear its ugly head a little bit more because of that uncertainty, but it doesn’t mean that there isn’t also opportunity.

Here Comes Earnings Season

Bud Kasper: Exactly right, Dean. That’s going to happen next week. So we’ll be taking a significant amount of time to understand earning season is beginning next week. So this is when corporations are going to come in and start reporting their profitability for the last quarter.

As we see that happen, I think you’re still going to see some solid numbers come forth. Hopefully, that will calm the concerns about the inversion and the stock market’s reaction, which is negative when it goes forward.

We have so much money on the sidelines, looking for a place to park it for future gains. If that cash flow stays in place, even with substantial increases in the Fed Funds Rate, let’s say another 1.5%, those earnings can still pull the stock market or be able to sustain the stock market without having serious damage.

Looking Back at the Great Recession

If we go back to the Great Recession, that deserves the word great because it was a 38.5% drop. But here’s a critical factor: How long did it take to recover from that? It was about three years.

Dean Barber: Yeah.

Bud Kasper: Three years.

Looking at the Bigger Picture

Dean Barber: Well, I was saying earlier that I think anybody within earshot of retirement must step back and say, “Okay, what should I be doing right now? How can I protect what I’ve accumulated? And what rate of return do I need to get over the next few years?” And if you’re already retired, it’s the same question.

You commented earlier off-mic about the retirement red zone. Saying, “Okay, you’re here, you’re close, you’ve won the game. All you have to do is make sure that you don’t lose it by messing something up or allowing some uncertain economic activity to cause you to lose the game.”

That’s where you have to step back and analyze your portfolio right now. The last couple of years were pretty easy, Bud. The rising tide lifts all boats. 

And as Warren Buffet says, “It’s not until the tide goes out that you see who’s swimming naked.” That means that not all industries and not all sectors will benefit or increase from here. There will be specific sectors and industries that will do better than others. 

Think about the NASDAQ 100, for example. The top 10 companies in the NASDAQ 100 make up 45% of the NASDAQ 100. There are many companies in the NASDAQ 100 that are far into bear market territory. If not for the Apples, the Microsofts, and the Amazons of the world, that entire sector would be in bear territory.

Technology Could Struggle While Interest Rates Continue Rising

So the technology sector, I think, is the one that could have the most trouble in this rising interest rate environment. Because a lot of those tech companies, especially smaller ones, are very leveraged. And so with that getting more expensive, that can be a problem.

Bud Kasper: Yeah. To be antagonistic to that, with the amount of cash that these big tech companies have on hand, they’re insulated for months with this. They have to keep doing what they’re doing and improve their product line.

Weathering the Storm of Inflation

So if you’re retired, or soon to be retired, and you’re seeing higher inflation, we all know what it means. It means higher prices for the goods and services that we use on a day daily basis. If that continues, and you’re in a static position in terms of the location of your money, you know you’re not going to keep up with the cost of living at that particular point in time. It’s a difficult situation but solvable with a financial plan.

Dean Barber: Right. Bud, I’m glad you brought that up because we’ve seen where individuals have come to us for the first time, and they’re saying, “Okay, we’d like a second opinion. We’d like to understand are we are doing things right?”

There are rare occasions when people have a comprehensive financial plan in place. But in those cases, Bud, the vast majority of the time when we peer into the plan itself, we see that the inflation rate assumed in the plan is 1.5% or 2%. And they say, “Well, here’s what it’s been over the last ten years.” Our take on that is, that’s a very, very dangerous thing to do. To assume only a 1.5% or 2% inflation.

Planning for Inflationary Circumstances

We’ve been assuming 3.5% to 4% inflation. And we’ve been assuming almost 7% inflation on health care. So if you change those inflation numbers, the plans, in many cases, were not working anymore. So, it is an issue.

You have to stress test your plan for uncertain market and economic conditions and a higher inflationary period.

Inflation isn’t something that causes a person to go broke, but it causes them to live like they’re broke. And that’s not what anybody wants in retirement.

We All Participate in Inflation, Like it or Not

Bud Kasper: We’re going to have higher inflation. It’s happening. 

And I like your point as well because if you don’t have a comprehensive financial plan that vets through taxes and all the other elements associated with this. 

We had to make the adjustments just a week ago to increase the inflation we’re using inside the plans to 3.7%. Okay? And as you said, we have the healthcare side of it at 7%.

So you have to put these in here. You’re not fooling yourself in terms of, “I’m not going to have a participation in that.” You will.

Dean Barber: Yes, you will. And there are a lot of complicated issues that go into building a solid retirement plan. 

But maybe we should have spent a little more time on inflation, Bud. Perhaps we can do that next week and discuss how different inflation rates applied to different parts of an individual’s budget can impact things. As opposed to saying, “Well, everything’s going to inflate at 3.75%.” Or, “Everything’s going to inflate at four.” That doesn’t work so well either. Some things will inflate slower than that, and others will inflate higher than that. You can nail that down and get a more pinpoint accuracy there.

We’ll Keep an Eye on the Bond Market, Earnings, and Inflation

As this next week progresses, Bud, we’ll continue to see what’s happening. Earnings season is starting, as you said. And the uncertainties out there, I think the volatility will stick around, but we’ll talk more about that and how to plan around that in next week’s show.

Dean Barber: Thanks for joining us on America’s Wealth Management Show. I’m Dean Barber, along with Bud Kasper. As always, we encourage you to reach out us. Schedule a 20-minute ask anything session or complimentary consultation with a CFP® professional here.

Everybody stay healthy and stay safe. We’ll be back with you next week. Same time, same place.

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