Markets & Economy
Bonds: Calm before the storm?
July 18, 2014
Catherine Gordon: Interest rates remain very low by historical standards and bond market volatility is also extremely low. Joe and Roger, with the economy continuing to grow do you think the bond market is overly complacent or is it telling us something we should be paying attention to?
Roger Aliaga-Díaz: It's really not about the whole global market, but clearly there are segments in which you can see credit spreads and risk spreads that are tight, especially compared to history. You see also [low] volatility, of course, as you mention, of interest rates and also of equity markets, [and] riskier assets in general, so that is concerning. I don't know if this really [is] the market or . . . the way investors are deciphering the code words that the Fed is trying to use in terms of forward guidance. The Fed has been trying to be transparent and trying to give as much information as possible, and investors tend to take that information too literally sometimes, and that's why the Fed is reminding investors that it's really data-dependent. So, information the Fed gives depends on how they see the world right now, but as data change, they will change their view. Investors tend to think that the predictions of the Fed . . . are almost certain, and that could bring a little bit of sense of complacency to markets that we are watching closely.
Joe Davis: All the volatility, as Roger points out, is extremely low and it could persist although history shows that it rarely persists for long. And so you know historically unexpected shocks on the economy with the policy front could jar volatility higher for a time. I mean one area that we contemplate potentially is that there is a growing risk that either because of a combination of decent job growth going forward in the United States as well as still-weak labor force participation—those Americans that perhaps have dropped out of the labor force [and] come back in—if they don't come back at such a vigorous pace, the unemployment rate, before the end of the year, could be below 6%, which is not in the Federal Reserve's projections.
That would change the conversation; so again, I would say returns over the past several years have been extremely strong. But if you look at low levels of volatility, they're commensurate with compressed risk premiums. But I think it's an outlook where the stronger the returns more recently have been I think the lower the expected future returns we should have. And so I think at the margin investors should at least reassess before taking more aggressive risk positions because investors have been rewarded, [and] they are unlikely to be rewarded to the same extent going forward.
Catherine Gordon: Thank you.
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Vanguard economists discuss bond market signals
In a short video, Chief Economist Joe Davis and Senior Economist Roger Aliaga-Díaz discuss what signals the bond market may be sending during a period of low volatility.
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- All investing is subject to risk, including the possible loss of the money you invest.