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Market Commentary - 7.30.14

Never Wrong, Just Early

Many forecasters who have made mistakes in their analyses tend to say that they were “never wrong, just early.â€쳌 Legendary Packers coach Vince Lombardi once said that his team never lost a game; the clock just ran out on them. Mid-way through 2014, the yield on the 10-year Treasury bond hovers around 2.5%, which has proven many forecasters wrong. Going into 2014, the 10-year Treasury yield was close to 3% and most so-called experts expected it to rise for the year. However, yields have done the opposite. Many pundits said yields could not go any lower, but they did just that. So, as we look back, how could so many be so wrong? Well, there are many factors that have contributed to the fall of Treasury yields in 2014 and, in fact, as we look to the balance of 2014, the “never wrong, just earlyâ€쳌 adage may actually pan out.

Supply and Demand
Many investors expected that as the Fed commenced “tapering,â€쳌 the scaling back of its bond repurchase program, the resulting excess supply in the market would depress bond prices and push bond yields higher. However, as the federal deficit decreases, fewer bonds are being sold. The federal deficit was reduced by almost one third in 2014, from $680 billion to $492 billion, as reported by the Congressional Budget Office. Although the Fed is purchasing fewer bonds, there are fewer bonds to purchase, so the net effect of tapering is not resulting in extensive oversupply as many investors feared. Moreover, there is also strong demand for U.S. Treasuries outside of the Fed. U.S. pensions are purchasing Treasuries to immunize their portfolios against long term payment obligations. Also, China continues to purchase U.S. assets in an effort to weaken their own currency, the Yuan, relative to the US dollar, in order to continue to make their exports attractive to U.S. consumers. It is estimated that the Chinese purchased over $107 billion in Treasuries in the first five months of 2014.

Geopolitical and Earnings Risks
In addition to supply and demand factors, 2014 has seen increased geopolitical risks coupled with mixed corporate earnings. Tensions in the Ukraine and Russia, as well as between the Palestinians and Israelis, continue to rise. The Middle East also appears less stable as Iraq is on the verge of a potential civil war. These geopolitical risks have caused Treasury yields to fall and gold to rise as investors seek safe haven assets.

Disappointing corporate earnings may also be a cause for some weakening in interest rates. GDP growth in the first quarter of 2014 came in far below expectations, and many companies reported being adversely affected by the unusually harsh weather, which caused a slowdown in productivity driven by blocked roads, closed workplaces, and consumers staying at home instead of shopping. While not all companies suffered, enough were hurt that the decline in overall GDP growth was the worst the economy has seen since the end of World War II. Fortunately, most attribute this pull back to the weather, which is a temporary condition and not one likely to continue into the other three quarters.

Looking Forward
The Fed’s tapering program is expected to be completed by the end of 2014. Treasury futures currently forecast the Fed to raise rates in mid- to late-2015. However, many fear wage inflation will rise as monthly labor market readings continue to improve, and this could pressure the Fed to increase interest rates sooner to combat inflation. So while bond yields this year have defied the odds, as well as the pundits, we believe it is inevitable that yield will trend higher in the near future and the “never wrong, just earlyâ€쳌 saying will actually prove accurate in this case.

As we are predicting a gradual rise in bond yields, we are recommending less interest rate sensitivity, as measured by duration, and a greater allocation to spread product, such as corporate bonds or mortgage-backed securities. While the additional yield from spread product may cushion a portfolio against a rise in interest rates, the overweight should remain within a client’s risk tolerance. As high yield spreads are tight due to the significant rally in this bond sector over the past few years, overweighting investment grade credit and upper-end below investment grade may also be prudent.

This information compiled by Cetera Financial Group is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular news update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. This is not an offer, recommendation or solicitation of an offer to buy or sell any security and investment in any security covered in this material may not be advisable or suitable. Please consult your financial professional for more information.

While diversification may help reduce volatility and risk, it does not guarantee future performance. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.

Affiliates and subsidiaries and/or officers and employees of Cetera Financial Group or Cetera Financial Specialists LLC may from time to time acquire, hold or sell a position in the securities mentioned herein.