In the 1980s and ’90s, the bond market was so nervous about a return to ’70s-era inflation that whenever economic growth began to look too strong, or it seemed the Federal Reserve was about to raise interest rates, investors would dump bonds. This pushed down bond prices and sent yields shooting higher.
These “bond vigilantes” were viewed as so powerful that James Carville, an adviser to President Bill Clinton, once joked that he wanted to be reincarnated as the bond market because “you can intimidate everybody.”
Today’s bond vigilantes are seemingly more focused on deflation than inflation. With memories of the financial crisis fresh in their minds, they pile into the bond market at the first sign of slowing economic growth, buying bonds and pushing yields down. While that has been good for price returns on existing bonds, it has pushed yields into low or negative territory. That makes life difficult for investors looking for the kind of steady income that high-quality bonds used to provide.
Why the bond vigilantes might be wrong
Despite the market’s pessimism, U.S. economic data suggest deflation is unlikely. The U.S. inflation rate is low, but it isn’t negative. The work force is growing, albeit slowly, not contracting. Prices in the service sector are holding up better than in the manufactured goods sector—and services represent a far bigger slice of the economy.
Nor does it appear that the U.S. is on the brink of slipping into a recession, which could cause inflation to fall significantly from current levels. With unemployment below 5%, wages edging higher, and the financial system much better capitalized than it has been for decades, the risk of deflation seems low.
Where will the Fed go from here?
Yes, the Fed thinks the country’s weak productivity growth is a source of concern. Productivity is a crucial ingredient for long-term economic growth. If productivity remains weak, it means the Fed probably has to keep interest rates lower for longer, to push the economy along and help stimulate job growth.
But what if the fears turn out to be wrong? Then the Fed could end up raising rates before the bond vigilantes expect. Fed officials continue to warn that a rate hike—maybe even two—is likely this year, but until Fed Chair Janet Yellen’s speech at the Kansas City Federal Reserve’s annual symposium in Jackson Hole, Wyoming, on August 26, the market wasn’t buying that view. Comments from Yellen and several other Fed officials suggest that there is room for one or even two rate hikes this year, and the market is beginning to take it seriously. The probability of a rate hike by year end, implied by the futures market, rose to more than 60% compared with 50% a week earlier.
Why is this risky? If you’ve built a portfolio based on the pessimistic view of the bond vigilantes, you could be in for some losses if the Fed moves faster and further than the bond market currently expects. That’s because bond prices fall when interest rates rise. You may not think that’s a problem if you’re holding bonds to maturity, but there’s also the opportunity cost of missing out on newer bonds issued at the new higher rates.
Elections: A game changer?
Though you wouldn’t know it from the headlines, the U.S. elections offer reasons to be optimistic about economic growth. Why? Both Democrats and Republicans have said they want to spend more on infrastructure, and that spending could boost growth. Stronger growth could mean higher inflation, which could mean rising interest rates.
So what can you do to be prepared either way? Make sure your fixed income portfolio is diversified, with a mix of different maturities and types of securities—this diversification can help you weather unexpected events.
Consider building a bond ladder, as well. This is a strategy in which you buy bonds that mature at set, but staggered, intervals. It lets investors avoid getting locked into a single interest rate. For instance, let’s say you bought a single five-year, fixed-rate bond. If interest rates should rise next year, that bond would still pay interest at the lower rate. However, with a ladder, there are bonds maturing every year, quarter or month, depending on the number of rungs in the ladder. When a bond matures, an investor could reinvest that principal in a new longer-term bond at the end of the ladder. Thus, the investor would benefit from a new, higher interest rate and keep the ladder going.
At current yields, the market is pricing in a fairly pessimistic view of the global economy, which means it is susceptible to upside surprises. We have great respect for the collective wisdom of the bond market, but times change … and so, sometimes, do bond vigilantes.
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.