I am seeing a steady and growing stream of articles suggesting bond volatility and liquidity are nearing Financial Crisis levels. Why is that and what does it mean for us?
The overall bond market, particularly the Treasury Bond market, drives the valuations of all other assets. When the Fed reduced short term interest rates to near zero (and numerous countries supported sub-zero interest rates), there was very little incentive to buy bonds. Who wants a zero percent return? To support such low rates, most financial authorities were also purchasers of their own bonds. For example, the Fed was the largest buyer of government bonds over the past ten+ years, growing their balance sheet to nearly nine trillion dollars.
That all changed earlier this year. The Fed has raised short-term interest rates from near 0 to about 3% in roughly six months. This is the steepest interest rate rise in history. And although absolute rates were certainly raised much higher in previous periods, the shock of going from 0 to 3% in 6 months is tremendous.
Net Sellers
On top of that, the Fed and other monetary authorities have quit buying. When the largest buyers of an asset up and quit buying, that will inevitably drive down the value of that asset. As you can see from the graph below, the Federal Reserve’s weekly purchases cried up around March / April of 2022 and have gone increasingly negative. And they have only just started.
What to Do?
With rates on the rise, stock markets inevitably decline as the incentive to buy risk-free Treasury bonds increases. Institutions are selling stocks and buying bonds. And even though many are praying for a Fed pivot, and some say the Fed has already done enough, I have never found hope to be a good strategy for investing. I have tried it. Many times.
The Fed has made it clear they are going to continue to raise rates and then to keep them at a restrictive level for some period of time. Even if a “Financial Accident” happens that requires some immediate Fed intervention, such accident will undoubtedly come with a significant crash of multiple markets.
In addition to keeping a net short position (which I am paring as the markets drop), I have a significant allocation to short term bonds. With rates still rising, a short-term position will allow you to reinvest it at a higher rate when your bonds mature. I am buying investment grade bonds with yields from 4-5 percent with maturities less than six months. Money markets are also a better investment than they have been in years, with most yielding from 2.5 – 3% interest.