Market Commentary - 9.3.14

Bond Investors Raise the White Flag after Labor Day

Among the fashionably well-informed, there is a saying that one should not wear white after the Labor Day holiday. While the origins of this faux pas are unclear, this moratorium on white clothing has ranked among etiquette sticklers' most sacred rules. In the first trading day after the Labor Day holiday, bond investors seemingly ignored this rule. No, they did not eschew tradition and wear white outfits that Coco Chanel would have been proud of. Instead, despite growing geo-political risks, bond investors took their cue from strong economic data and raised the "white flag"쳌 on Treasuries, sending prices lower and pushing yields higher. Going forward, we continue to believe market volatility will be commonplace and that there is an embedded bias to higher interest rates.

As investors returned from their extended holiday weekends, they were met with a flurry of stronger than expected economic data. On the manufacturing front, the Institute for Supply Management's manufacturing activity index jumped from 57.1 to 59.0 in August, the fastest pace of expansion in three years. The near two-point jump was led by a surge on the New Orders index component, which rose from 63.4 to 66.7, the highest level since April 2004. Another manufacturing report, the Markit Economics PMI August index, rose from 55.8 to 57.9, the highest level of expansion since April 2010. The Commerce Department reported that construction spending rose 1.8% in July, stronger than consensus estimates. Lastly, it was reported that U.S. homes prices rose 1.2% in July to stretch year-on-year gains to 7.4%. As bond investors saw the string of better-than-expected economic readings, they sold out of Treasuries. The 10-year Treasury note saw its yield, which moves inversely to price, jump from 2.34% prior to the Labor Day holiday to around 2.42% after the data releases.

With many signs of geo-political risk and potential volatility, why did bond investors raise the white flag and sell out of Treasuries? In general, the worst for bond investors is unexpected inflation. Most bonds offer investors a fixed coupon for a specified period of time, but if they underestimate inflation, future proceeds from their investment may have less purchasing power. The Federal Reserve is very aware of this concern and as part of its interest rate policy, can raise short-term interest rates to combat the threat of higher-than-expected inflation. The post-Labor Day strong economic data increased the possibility that the Fed will move to raise rates sooner than previously expected.

We continue to believe that the improving global economy will push bond yields higher. Clearly it has not been the case so far this year as yields have fallen on rising global tensions (Treasuries act as a safe haven in times of uncertainty) and a seemingly lack of inflation readings. However, if geo-political tensions begin to subside and U.S. economic strength continues to surprise on the upside, triggering greater inflation risks, bond yields may continue to move higher. While the threat of higher yields is of concern, we would not raise the white flag and completely sell out of all bond holdings. Bonds play an important role in an investment portfolio, especially for those investors who are dependent on current income or planning for future expenditures or as a diversifier to equity risk. Instead, we continue to believe in repositioning bond holdings by reducing interest rate sensitivity (i.e. duration), overweighting spread or non-Treasury holdings, and being more diversified through alternative investments.

This information is compiled by Cetera Investment Management.

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