Most investors are familiar with the seasonal pattern in stocks, encapsulated by the old adage, “sell in May and go away.” But is there a similar pattern on the fixed income side of the equation? That’s what we’re going to take a look at today.
Back in 2015, three researchers, Mark Kamstra, Lisa Kramer, and Maurice Levi, wrote a research paper titled, “Seasonal Variation in Treasury Returns.” What they found is that the US Treasury market exhibits an annual cycle in which average monthly returns vary over 80 basis points (0.8%) from peak to trough.
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They attribute the seasonal pattern to changes in investor risk appetite, which has also been shown to follow an annual cycle. But the main takeaway here is simply that fixed income markets also exhibit statistically significant seasonal tendencies. So what are they?
Daniel Kruger, from the Wall Street Journal, recently worked with the WSJ Data Group to try and tease out this seasonal behavior from the data. What they found is rather interesting.
As you can see in the chart below, over the last 20 years Treasury yields have had a tendency to climb during the first part of the year (January - May) and fall during the back half of the year (June - December).
The overall change in yield due to this “seasonality” is about a quarter of a point, which isn’t all that much in the grand scheme of things, but it can represent a big move when all eyes are focused squarely on rates, as they are now.
One of the possible drivers for this behavior in yields may be related to measures of inflation, which of course influence the level of compensation bond investors demand. As you can see in the chart below, the Consumer Price Index (CPI) also tends to follow a similar seasonal pattern. Once again, the early part of the year (January - May) seems to have much stronger increases in the CPI than we see during the rest of the year (June - December).
Is it possible that this seasonal tendency is what has caused rates to move from 2.4% (where they began the year) to roughly 2.9% now? The answer is more than likely – no. While seasonality may be playing a role, we’ve got a lot of factors right now that all seem to be leaning on interest rates to move higher.
For example, weakness in the US dollar (shown below), has caused a sharp rise in imports. The US import price index has risen 3.6% over the past year, and by 1.9% if we exclude fuels.
I don’t want to spend a lot of time talking about the dollar, but as you can see above, we are at a rather interesting technical level. After having fallen precipitously during Trump’s entire term, the dollar is now bumping into long-term support near 89. This level also coincides with a rising trendline that has been in place since 2011.
Adding to the “fun,” we’ve seen the dollar index plunge below the 89 level during three out of the last four weeks (see smaller chart on the right side above), and yet recover to close above that level. On a daily chart, this is playing out as a potential double bottom near the 88.5 level. With so many technical crosscurrents, it will be interesting to see where the dollar heads over the next couple of months.
Getting back to rates, we also now have a concerted effort toward central bank tightening. The European Central Bank recently reduced its monthly bond purchases to 30 billion euros (instead of 60 billion), with the program set to expire in September. Meanwhile, the Bank of Japan has signaled it will reduce purchases of government bonds by 5%. That may not sound like much, but it’s a step away from the easy monetary policies that have characterized this recovery.
The Fed is also on the same path, and well ahead of the rest of the world. They are scaling back reinvestment of their bond portfolio, which means less demand for longer-dated US Treasuries.
Interestingly, this comes at a time when Treasury issuance (supply) is rising, as a result of the tax cuts and budget plan. It’s estimated that the tax cuts will add .5 trillion to our nation’s debt over the next 10 years. The budget plan is estimated to boost the deficit by 0 billion.
Altogether, this points to falling demand and rising supply, which, if you’ve studied any economics, points to lower prices. And lower bond prices, of course, mean higher rates.
What will be interesting to see is just how much demand for bonds comes out of the woodwork from global investors as rates do tick upward. Will we see investors step up their purchases as rates cross 3%? 3.5%?
An important factor here will be what happens to rates in other developed countries. The German 10-year currently yields 0.73%, while Japan’s 10-year sits at 0.06%. With “competition” this low, it seems likely that rates across the rest of the world will need to rise as well if we’re going to see materially higher US rates ahead.
If yields on other government debt remain subdued, it’s hard to see Treasury yields rising substantially because international buyers are likely to step in. But of course, this is also heavily dependent on how the US dollar is expected to perform, as few international investors want to hold dollars while the currency is in a prolonged downtrend.
In my opinion, right now a lot hinges on the direction of the US dollar. Its decline over the last year has been substantial and that has really helped to boost inflation. If the dollar continues lower, then I think inflation concerns will continue to build and we’ll see higher rates ahead.
But on the other hand, if the dollar decides to change course, it could easily put the kibosh on rising inflation expectations, just as it did in 2014. This would relieve some of the upward pressure on rates, which would, in turn, alleviate some of the downward pressure on stocks.
So keep your eyes fixed on the dollar. It’s currently sitting at a technical crossroads, and where it heads from here could give us an indication of how fixed income and equity markets will behave moving forward.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
