One of the most talked-about issues in the bond market is whether the U.S. Federal Reserve’s decision to raise short-term interest rates will trigger a dreaded bear market. The topic is frequently discussed in dramatic terms, fostering the paranoia that the bond market is on track for a crash.
Such a bond market meltdown would be characterized by a sudden drop in the value of bonds, although the likelihood of this taking place doesn't make much sense. The media has continually discussed the possibility of bond prices being in a bubble. A meltdown is a sudden-letdown stage the follows the bubble.
Some Bond Terminology
It helps to keep concepts straight, such as a bond market bubble.This occurs when people in the market drive bonds up over their value, as determined by a bond valuation.
A bond market meltdown, on the other hand, is perhaps the outcome or the aftermath of a bubble that has burst, and you would see bond prices dropping dramatically over a short period of time.
Any Effect Would Be Gradual
In reality, the bond market’s reaction to the prospect of Fed rate hikes is typically gradual. Bonds are likely to suffer modest price pressure over an extended period of time, not a sudden, dramatic meltdown of a crash. This should result in both higher volatility and an extended period of lower returns, but the odds of an outright crash are minimal.
The closest thing to a bond market crash occurred in 1994 when the Fed mismanaged policy by raising rates too quickly, but even then the loss was only 2.9 percent—hardly a "crash."
Bond Market Meltdowns Are Rare
A look back through the return history of investment-grade bonds shows a track record of stability over last 30-plus years. Skeptics will note that this period largely incorporates a bond bull market, and that’s true. So what does a bear market look like?
Investors might recall that the late 1970s was a period marked by soaring inflation—the worst possible condition for the bond market. Bonds responded unfavorably, but losses were modest even in this case.
According to a database kept by Aswath Damodaran of NYU’s Stern School of Business, the 10-year U.S. Treasury note produced the following total returns in each calendar year during this time, from 1977 through 1980:
- 1.29 percent
- - 0.78 percent
- 0.67 percent
- - 2.99 percent
Granted, yields were higher then. There was a larger yield cushion to offset price declines. But these numbers show that no crash occurred even in the unfavorable conditions of that time period. Investors who remained in the bond market more than made up for this period of weakness with the strong returns that occurred in subsequent years.
Fed Rate Hikes Are a Known Issue
Markets typically only exhibit violent reactions to surprising developments, not to issues that are known well in advance. And Fed rate hikes are gradual and almost always known in advance. This is probably the most important reason why a bond market crash is extremely unlikely.
The markets knew beginning in 2013 that the Fed would start hiking rates in mid-2015. Investors had plenty of time to prepare, and it removed the element of surprise from the equation.
Although the timing of the first hike remains a key factor for the markets, don’t expect a major downturn in the weeks leading up to a Fed announcement that it's boosting rates, or even on the day of the announcement itself. The markets simply don’t respond that way to events that are anticipated so far in advance.
The Market Is Already Reacting to the Shift in Fed Policy
The expectation that the Fed will raise rates is reflected in market prices before the event occurs. Even as longer-term bonds have performed very well under these circumstances, the yield on the two-year U.S. Treasury note has risen.
The two-year note is the maturity that has been the most sensitive to Fed policy. Its performance against longer-term bonds indicates investors' readiness for rate hikes. It greatly reduces the odds of a crash when investors shift their portfolios in advance. A crash generally only occurs when investors all try to hit the exit door at the same time.
The Fed Is Watching the Markets Closely
It’s also important to keep in mind that it’s the Fed’s objective not to take any actions that would lead to bond market volatility. Any decision that would disrupt the financial markets would feed through into the economy, and this in turn would force the Fed to adjust its policy.
The Fed's rate decisions are meant to steer the market toward sustainable stability. The Fed also has made it their practice to communicate policy decisions and prepare the markets for the timing and extent of their interest-rate adjustments. This eliminates the element of surprise and reduces the odds of a crash.
Overseas Pressures Keep a Lid on Rates
The U.S. bond market doesn’t operate in a vacuum. Economic conditions and bond market performance overseas have a direct effect on our market.
Europe’s economic slowdown in 2014 and the potential slide into dangerous deflationary territory is a good example. Prices falling rather than rising drove down yields across Europe. This made the relatively higher yields in the U.S. Treasury market more attractive. It created a wellspring of demand that brought in buyers as yield rose rapidly.
The takeaway: The steady U.S. bond market can be a haven for FX investors. The odds of a bond market crash in the United States are very low when Europe or another major foreign market is struggling.
Investors Are Conditioned to a “Crash” Mentality
Many investors lived through the stock market crashes in 2001 and 2002, and again in 2007 and 2008. Many more experienced the intense bond market sell-off that occurred in spring 2013. These events fostered an undercurrent of fear among investors.
This fear is stoked by stories of potential crashes in stocks, high yield bonds, and investment grade bonds. The reality is that "everything will be fine" media reports don't get anywhere near the kind of readership that "doomsday is imminent" coverage gets. Individual investors should be skeptical of discussions of potential market calamities and focus on common sense and context.
What Does This Mean for the 2018 Doom and Gloom Reports?
The "doomsday is imminent" coverage was pretty rampant by mid-2018...again. Bank of America Merrill Lynch's Global Fund Manager Survey indicated at the close of 2017 that 22 percent of global investors feared a significant drop was coming. Keep in mind that global bond yields hit rock bottom in 2016 but they've logically rebounded since then because of the above interlocking factors.
Meanwhile, the 10-year U.S. Treasury yield peaked at a significant high just a couple of months later in January 2018. But the doom-and-gloomers were equally alarmed by this, foreseeing a dive at some future point in time when so many investors might begin selling. In fact, Bloomberg Barclay's Aggregate Bond Index did indeed show a drop by June 2018 of 2.7 percent.
But that's not a "crash" and it's certainly not an indicator of a certain bear market in the months ahead.
The Bottom Line
A protracted period of lower returns is almost certain, higher volatility is probable, and a bear market may well be in the cards when the Fed hikes rates. But the odds are heavily against the type of calamity you’ll often see discussed in the financial press.
Consider ways to position your portfolio for the changing environment, but don’t let the fear of a bond market crash get the better of you and end up costing you money.