When the Fed raises rates, it’s usually a sign of rapidly rising inflation or torrid economic growth.
After the Fed’s latest move, however, it looks like the bond market thinks otherwise.
How else to explain the razor-thin gap in yields between five-year Treasury notes and 30-year bonds?
Historically, investors anticipating rising inflation, demand more yield when committing their funds to longer-term bonds. Today, though, the gap between long- and short-term bonds is barely discernible: about 96 basis points, the narrowest since December 2007, according to Reuters.
In other words, what we’re seeing is a flattening yield curve, a trend we’ve expected for some time (What the Yield Curve is Telling Muni Investors).
You can’t dance to every Fed tune
When looking for hints on where the economy – and inflation – are headed, investors often turn to the Fed. So when it raised rates on June 14th for the third consecutive time, many Fed watchers thought they received the signal they’ve been seeking for so long: the economy is finally heating up.
But a closer analysis tells a different story.
While the unemployment rate has inched lower, the economy remains less than robust.
Inflation, excluding food and energy, slowed in June for the fourth straight month. At 1.7%, May’s inflation rate was still below the 2% targeted by the Fed. Further, the Fed’s median projection for inflation in 2017 fell to 1.6%, from 1.9% forecast in March.
Regardless, the Fed still expects to bump yields once more this year.
The Fed’s move comes at a time when individual investors are cooling on stocks. For the week ending June 21, investors withdrew $2.2 billion in U.S. equity mutual funds and exchange-traded funds, Reuters reported.
Demand for municipal bonds, meanwhile, continues to outstrip supply (Summer Forecast: A Muni Redemption Flood, Supply Drought).
Caution for muni bond investors when using the Fed as barometer
Successful muni investors don’t use the Fed as a guide for committing funds to the market.
We would avoid the subject of market timing entirely if we weren’t concerned for individual investors heeding the advice of financial pundits granted expert status simply by their presence on TV or their columns online.
These would-be soothsayers continue to advise investors to avoid bonds when they foresee a “rising interest rate environment” and to buy bonds when their crystal ball predicts rates will decline.
Bond investing should not be a guessing game or a quest for capital gains. For those who choose this approach, we wish them well. We admit to having no such expertise.
Our goal is to deploy investable dollars when available to generate a steady, dependable stream of tax-free income.
Committing time, and forfeiting the opportunity to generate tax-free income, while trying to guess where interest rates are heading is a futile and costly exercise.
Don’t play that game.