Improving Labor Market Unlikely to Hurt Low Duration Bonds

    The BLS Employment report was released today showing 134,000 new jobs. Adjusting for 125,000 monthly population growth, of those likely to want to work, implies the net increase was only a few thousand jobs in a nation of 144million job holders and is thus a near zero growth rate. The unemployment rate decreased because less people attempted to participate in the workforce.
When the unemployment rate is this high it is a sign of an overheated economy that will fall into recession in a year. Stocks may anticipate this a half year early so if recession come sin 12 months then stocks could crash in 6 months.

   100% of the increase in employment went to those with no college degree, since May. This means the new job holders are the lowest paid, least skilled and are thus unlikely to qualify for loans and thus unlikely to contribute to inflation. They will use paychecks for low cost, low margin commodity goods and thus create less inflationary growth than that created by the activities of a more affluent person.
The bond yield for the ten year Treasury went up 0.05% this morning to 3.23%. Assuming the Fed estimates the neutral real rate is 1% and inflation is 2.2% then they will try to raise Fed funds by 1% to 3.2% over the next year. Already the two year Treasury Note is at 2.9%, so the market has already adjusted, partially, to the anticipated increase. By the time Fed funds reach 3.2% the yield curve will have inverted, so the two year Note may still be near 2.9%. Regarding two year Notes there is a good chance yields won’t get higher than 3.3% over the next year. If it goes to that the loss would be about 0.8%, but the coupons could be invested at higher rates and thus the total return would be better than a 0.8% capital loss, plus the Note owner would get the coupon payments. The main risk for bonds are long duration bonds; if their yields rise to a 1% higher yield the price could drop 9% for a ten year bond.

   The risk to the economy is that rising rates will damage stocks by lowering corporate earnings and by damaging the earnings discount model which depends on low interest rates to justify high stock valuations. (Note: no amount of ultra-low rates justify today’s absurdly high PE ratios). When rates rise then stocks and bonds can drop in value.
Using the PE10 theory and other similar theories, stocks may drop by 60%, while a ten year Treasury might only drop 9%, thus the real risk of rising rates is that stocks will crash.
I suspect that employers won’t pay up for quality capital goods needed to improve productivity and this will limit their ability to give pay raises.

   Investors need independent financial advice about the risks of a stock crash caused by rising interest rates.

2018-10-05T09:49:08+00:00October 5th, 2018|mayflowercapital blog|Comments Off on Improving Labor Market Unlikely to Hurt Low Duration Bonds

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.