Last Friday’s U.S. Employment report was strong enough to send interest rates soaring. The 10-year note, which opened the year yielding 2.17% and dipped all the way below 1.64% at the end of January, has erased that entire move and then some. As of Monday evening the 10 year yield is 2.24%. The five year and the 30 year have likewise completely given up their sizable January gains. The Employment report is allowing the bond market to exert pressure on the Federal Reserve to be more specific about its plans to raise interest rates. On January 26th the bond and stock markets believed the Fed was on hold all year, despite the Fed’s hints that the first tightening may come as early as June. Right now, almost nobody believes the Fed is on hold all year (though some believe a rate hike to be unwise).
The low rate environment over the past six years has been exceptionally good for financial assets. The potential end of it, even if it is several months off, should give investors pause. U.S. stocks are priced (as a whole; there are exceptions) for the best of all possible environments. This is a dangerous time for investors. Confidence could break like a dam.
The dollar has been the obvious winner as the U.S. economy continues to show much more robust job growth than the rest of the world. The dollar has climbed above 1.10 to the Euro, with almost complete consensus that parity will ultimately be tested. UUP has been a way to play the dollar’s rise; it has gained almost 7.5% year-to-date. Buying almost anything dollar-hedged has also been wise. Buying European equities via a dollar-hedged fund like the Wisdom Tree Europe Hedged Equity (HEDJ) has resulted in a 17% gain this year, while buying Japan via a dollar hedged portfolio like the Wisdom Tree Japan Hedged Equity (DXJ) has produced an 11% YTD increase.
Getting back to bonds, I believe they were overbought on the notion that U.S. Treasuries were very attractive relative to negative yields on many European bonds and virtually no yield in Japan. This matters, but so does the opposing fact that a stronger economy is theoretically going to increase the demand for credit and therefore push interest rates up. At the very least, it is going to force leveraged speculators out of their long Treasury positions. I am not persuaded at all that the secular trend toward declining interest rates is over. Worldwide, economic growth continues to decelerate, and commodity prices remain surprisingly weak. It is my belief that we are getting a buying opportunity in high quality, long duration U.S. bonds. Timing-wise, it may be prudent to wait until the Fed announces the first rate increase. That is when we should see concerns about the economy rolling over into recession positively impact bond prices.
One can’t help but notice that “growth” has dramatically outperformed “value” so far this year. As the stock market advance gets into its later stages and interest sensitive equities and cyclical stocks no longer participate, investors look for those entities that can grow sales even with an interest rate headwind. Typically these are found in the health care, technology, media, and specialty retail sectors and tend to have higher P/E ratios. Over-weighting growth makes sense now as a trade, but it must be emphasized that when growth outperforms value to this extend it tends to be the last thrust of a bull market. Trade accordingly.
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