The Bond Market Could See This Scenario in the New Year

NEW YORK (Real Money Pro) -- Most people call their musings on 2015 a "forecast" piece, but in my old age I've begun to eschew that word. This Web site is called Real Money Pro for a reason, and I don't manage money via forecasts or predictions. Why write a bunch of predictions that even I don't trust enough to trade? Rather, I think in terms of probabilities and possibilities.

I ask myself a series of "what if" questions, reason out how such a scenario might develop, and then think about what trades could work across multiple scenarios, or at least work great in the more likely scenarios and not too badly in the other scenarios.

I will break this into two parts, with today's column on interest rates and Friday's on credit.

What if interest rates rise substantially?

The most likely reason why this would happen is the economy accelerates in the first and second quarters, which either pulls Federal Reserve rate hikes forward into the spring and/or causes the Fed to raise rates more aggressively come the summer. The former would cause considerable volatility, but, ultimately, the latter is more impactful, and thus where I'm focusing my time.

The key factor is employment. If job gains continue at the current pace, unemployment will hit 5.0% by June, and the Fed will have hiked at least once by then.

What if interest rates fall?

It is hard to imagine short-term (0 to three-year) interest rates falling. That would require the Fed hiking only once or twice and it subsequently becoming clear that it isn't going to hike again for a year or more. That would cause two-year Treasuries to drop into the 0.50% area, from the 0.68% area now.

It's not quite as hard to imagine, but still highly unlikely, that five-seven year bond yields fall. In order for that to happen, the pace of Fed hikes would have to be seen as extremely slow, like 0.25% worth of hikes every four months or so. It would also require an assumed early stopping point, certainly no higher than 1.75%. So, basically we're talking a scenario where the Fed hikes six to seven times over a 2 ½ year period.

Long-term rates are a different conversation. In order for rates on bonds 10 years or longer to fall all you need is an assumption by the market that rate hikes are going to stop in the 2.25% to 3.00% area and move relatively slowly (like 0.25% hikes every two months) to get there. Or else, the presumption is that the economy will go back into recession in 2017.

What about inflation?

I didn't mention inflation in the "rates rising" scenario because I believe the scenarios where inflation picks up are also scenarios where employment gains accelerate. I don't think conditions are right for stagflation now.

It is worth noting that a big bet on inflation would be about the most contrarian bet you could make. No one in the rates complex is expecting inflation. But I also don't see a huge payoff if this bet turns out to be right. At one time I thought it was plausible that the Fed might allow inflation to accelerate to 3% or higher before hiking at all. At that point there might be enough pressure in the system to carry CPI all the way to 4%. However, it is now clear that won't happen. So any mild acceleration in current inflation readings will just cause the market to price faster rate hikes as opposed to a higher steady-state rate of inflation.

Given that, a mild acceleration in inflation, to 2.5% or so, will be seen as temporary and thus unimportant for pricing bonds. What will matter is that the Fed is acting.

What are the odds?

I find it highly unlikely that the Fed won't hike at least once or twice in the middle of 2015. We have too much momentum already to imagine it all cratering over the next six months. For instance, by the time job gains turned negative in the spring of 2008, the pace of gains had been slowing for 2 ½ years. Right now we're still accelerating.

The scenarios where 0 to seven-year rates decline are farfetched to me. Possible, but it requires a convoluted set of assumptions to get there. It has been much more common for the Fed to start a hiking cycle and then keep moving rates higher at a consistent clip until it starts to see a negative impact on the economy. I can certainly see the Fed hiking twice and then pausing, but unless the economy immediately heads into the tank after those first two hikes, the market will price bonds as though the rate-hiking cycle is resuming.

What's the trade?

I think the market is underestimating the Fed and hence is overly sanguine about the risks in three- to seven-year bonds. I'm outright short this part of the yield curve and have pressed that position just before Christmas. I've been especially active in adding seven-year shorts, whereas before that I was mostly just short three- to 5-year bonds. I like this trade because I think the potential downside is pretty low. I think the 1.40s is probably the floor on fives and the 1.70s on sevens. The biggest risk is really that I'm paying carry and therefore if the Fed just prolongs its rate hikes, I won't make much from this trade. But "won't make much" isn't a bad downside for a trade!

On the longer end of the curve, I made a lot betting on long rates falling in 2014. Today, the 30-year is through my fair value estimation of 2.90%-3.00%, so I'm not bullish outright any longer. However, owning some 20- to 30-year bonds is a good hedge against my three- to seven-year short. The scenarios where three- to seven-year bonds hang around this level or even fall are scenarios where long-term rates fall as well.

This article was originally published on Dec. 30 at 4:00 p.m. EST on Real Money Pro.

Tom Graff trades taxable fixed income for Brown Advisory, an independent investment advisory firm in Baltimore, Maryland.

Prior to joining Brown, Graff was a Managing Director and taxable fixed-income trader for Cavanaugh Capital Management in Baltimore. Graff earned a CFA charter in 2001.

The opinions expressed here are Graff's own and in no way the statements of Brown Advisory, and may or may not reflect the strategies being pursued for clients of Brown Advisory.

Tom welcomes your questions and can be reached at tomgraff@brownadvisory.com.

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