How Memphis Firm Decoded Bond Secrets Mystifying Wall Street
Working for a firm based about 1,000 miles (1,600 kilometers) from Wall Street with roots that date back to the Civil War, FTN’s Jim Vogel and Chris Low were among the few who correctly urged investors to ignore the consensus calling for an inevitable selloff in bonds this year. Since at least 2011, FTN’s head of interest-rate strategies and chief economist have rightly gone against the pack by calling for low yields.
While the bears point to signs of budding inflation and reduced purchases by the Federal Reserve as reasons to stay away from bonds, FTN says Treasuries -- the global benchmark for everything from home mortgages to emerging-market debt -- are years away from reverting to pre-financial crisis levels as the labor market struggles. Getting it right has never been more important after a borrowing binge helped push the amount of debt globally to $100 trillion from $70 trillion in 2007.
“If you don’t expect interest rates to go back to where they were in the last cycle, you’re essentially asserting that something is very different in this cycle,” Low, 49, said in a June 24 telephone interview. “You can make that case more easily with every year that goes by when growth remains weak and several hundred thousand people fall out of the labor force.”
Bond investors following consensus forecasts would have missed out on global returns this year that average 4.2 percent, the best since at least 1997 when Bank of America Merrill Lynch indexes began tracking the data. Treasuries have returned 3.1 percent after losing 3.4 percent in 2013.
FTN, with offices 11 miles from the musical gates to Graceland, was one of 12 forecasters in a Bloomberg News survey of 67 in January that predicted yields on Treasury 10-year notes would be below 3 percent by June 30. FTN’s forecast of 2.6 percent compared with 2.52 percent as of 12:42 p.m. in New York.
Economists and strategists say they weren’t wrong, just early. The median estimate in a survey taken from June 6 to June 11 is for yields to end the year at 3.07 percent. Vogel and Low are calling for 2.55 percent.
FTN lowered its estimate today for the near-term range for the 10-year yield to 2.48 percent to 2.62, from 2.55 percent to 2.68 percent, citing “deteriorating expectations for the economy along with gradually shifting central-bank policies,” in a note to clients.
Surveys by Bloomberg show the consensus has a track record of overestimating yields after the Fed cut its benchmark interest rate to virtually zero in 2008 to bolster the economy in the wake of the demise of Lehman Brothers Holdings Inc. and the collapse of the housing market.
Quarterly forecasts for 10-year yields made 12 months forward have overshot market outcomes by an average of 0.68 percentage point since January 2009. That’s because the consensus expected the Fed’s actions to result in more spending and inflation, as has historically happened when the central bank eased monetary policy.
“The market has assumed for the past couple of years that you’d see a pattern like we had in the past, so you have this expectation of higher rates,” Priscilla Hancock, a global fixed-income strategist with J.P. Morgan Asset Management in New York, said in a June 25 interview.
The asset-management arm of the biggest investment bank by revenue has lowered its year-end forecast for the 10-year yield to 3 percent from 3.5 percent.
Anticipated bond losses have been pinned to signs of faster economic growth that would allow the Fed to stop buying Treasuries and mortgage securities as a means of injecting cash into the financial system and eventually raise rates.
The Labor Department’s June 6 report showed nonfarm payrolls grew in May to above the pre-recession peak. Less than two weeks later, the consumer price index for May increased 2.1 percent from a year earlier, the biggest jump since 2012.
Other data reveal the uneven nature of the recovery. The so-called participation rate, which shows the share of working-age people in the labor force, held at 62.8 percent in May, matching the lowest since March 1978. Wages and salaries have increased 2.5 percent year-over-year on average since the recession, compared with 4.3 percent in the previous expansion.
An aging population, less spending, slower inflation and greater demand for low-risk, income-producing investments, will keep yields low for years to come, according to Jeffrey Gundlach, the star fixed-income manager at Doubleline Capital LP in Los Angeles whose mutual fund beat 96 percent of its rivals the past three years.
Estimates for U.S. growth in 2014 were marked down to 2.2 percent from 2.5 percent the month before, according to economists in a June 6 to June 11 Bloomberg survey. The International Monetary Fund lowered its forecast on June 16 to 2 percent from 2.8 percent in April.
“Some of the growth we wish we could go back to was far more frail than most people realize,” FTN’s Vogel, 58, said in a June 23 telephone interview. Economic growth averaged 2.8 percent during the previous expansion from the end of 2001 through 2007.
Many forecasts for higher yields reflect the teachings of “old analysis” that has become less applicable in an economy where more than three years of rising employment has yet to be joined by higher wages, Vogel said.
The market for interest-rate futures shows traders are lowering their estimates of how high the target federal funds rate will go once the central bank starts tightening. Prices now show it ending up at 3.13 percent, compared with bets of more than 4 percent at the start of the year.
In January 2011, when 10-year yields reached 3.49 percent, FTN was the only firm in a Bloomberg survey of 70 analysts to predict the yield would fall to 2 percent. The median estimate was 3.75 percent, while the yield ended the year at 1.88 percent.
In May 2012, when the 10-year note was trading at 1.79 percent, Low said Europe’s financial turmoil and slow growth might push 10-year yields to 1.5 percent. The yield fell to a record low 1.379 that July.
Low started his career in 1987 at Carroll McEntee & McGinley, a primary dealer. Low joined FTN, which trades bonds with institutions and advises on fixed-income portfolios, in 1998 when it opened its New York office. He has been collaborating with Vogel on interest-rate calls since 2000.
After leaving his first job as a business reporter for a now-defunct Memphis newspaper in 1978, Vogel was hired by FTN, working in the corporate treasurer’s office, then moving to fixed income in 1982.
The bond market consensus is coming around to the view of Vogel and Low. The year-end 10-year yield consensus has declined to 3.05 percent from 3.44 percent in January. Citigroup Inc. lowered its projection on June 27 to 2.95 percent from 3.35 percent, citing the Fed’s reduced estimate for the ultimate level of its federal funds rate target.
Traders are finding it too expensive to keep betting against bonds, forcing them to buy the securities to exit their so-called short positions, said Jim Bianco, president of Bianco Research LLC in Chicago. He said he expects 10-year yields to fall to 2.25 percent this year.
“The relationship between nominal growth and interest rates is not as strong as they think it is,” Bianco said in a June 25 telephone interview. “If you want a fundamental reason for the squeeze, the growth is not there. If rates go to 3.5 percent, every single person makes money on it except Chris Low and me, because we’re the only ones who are bullish on the market.”
To contact the reporter on this story: Daniel Kruger in New York at firstname.lastname@example.org