Bonds: Confined but Happy

While bonds don’t have the potential growth that stocks do, bond holders enjoy considerably more certainty when stock markets stumble. This is reflected in both the Q4 numbers and returns for all of 2018.

The bond market had already expected rates to rise and those increases were priced into the market. When stock markets started to slide, demand for bonds increased, raising prices and decreasing yields.

This increased demand also generated a signal that very much concerned stock investors: an inverted yield curve for some bond maturities. A normal yield curve is drawn when longer-term interest rates are higher than shorter-term rates. When demand for bonds increases, especially due to a worried and weak stock market, the money from the stock market shifts to bonds and those shifts generally go to longer term bonds as the chance of a recession increases. An increase for demand in longer-term bonds increases their prices, forcing their yields down. Eventually, the demand for longer-term bonds brings their yields down lower than short-term bonds. This inverts the yield curve (higher short-term rates than long-term rates), which is a classic indication of an upcoming recession.

Of course, predicting the future isn’t as easy as just looking at relative bond prices. A flattened or inverted yield curve has preceded many recessions, but not all, and the timing has varied greatly from the time of inversion to the time of a recession.

Given all of this, Jerome Powell, Chairman of the Federal Reserve, has become more careful in his statements. Suffice it to say that interest rates may not be increasing as rapidly as thought a year ago. Low interest rates not only benefit the bond market (bond prices rise when interest rates fall), but also any sector that requires heavy borrowing, like residential construction and sales, or industrial companies that want to finance new plant and equipment, etc.

In summary, the stabilizing properties of bonds were appreciated by most investors in Q4. Looking forward, the Fed is now saying that interest rates will rise in 2019, but not as much as was thought earlier.