In our last post for the 2018: The State of the Bond Markets Part 2 report, we reviewed where the U.S. economy stands as well as quantifying the government's total debt outstanding. The monetary stimulus that has been injected into our economy is larger than anything tried before, and we expressed our concerned that any hint of inflation may cause interest rates to rise rapidly due to this monetary stimulus leftover in the system.
The chart below shows the potential impact of a 1% increase in interest rates across the yield curve. While not quite linear, we can estimate the potential losses of a 2% or 3% rate rise by multiplying the numbers above. Remember the Fed has already increased rates by 1 ¼% on the short end of the curve and with trillions of dollars of QE reversal, it’s reasonable to assume that rates are going to rise. The only questions are how far and how fast? What many don’t realize is that such a dramatic and sudden drop in bond prices could send shock waves through the bond and equity markets.
Finally, on the credit side, we are pleased to see that high-yield or junk bonds have had a remarkable run and are still enjoying market calmness and low yields. However, as the chart below shows, it may not take much in terms of industry default to expose this sector of the bond market as well.
Note how yields rose rapidly and quickly with the bankruptcies due to the oil bust in 2015 and 2016. Now that we are experiencing what pundits are calling the “Brick & Mortar Meltdown”, will we see the same results?
Will online sales further derail the bonds creditworthiness of U.S. retailers? We at BCM learned long ago that making predictions over short periods of time can be a fool’s errand. We are not making a prediction as we truly do not know what the future will bring. However, it is prudent to look at long-term trends, it is prudent to pay attention to macroeconomic policies and events, and it is prudent to understand that the remarkable returns that the bond markets have enjoyed for decades may face the first serious headwind since most in the business can remember. Perhaps it is time to review your portfolio’s bond duration and credit exposures to prevent any unwanted surprises.