Why bondholders will lose if FOMC cuts rates
This month's reads on the economy show continued weakening, which will allow the Federal Open Market Committee to cut the fed funds rate target 25 basis points to a range of 1.5% to 1.75% when it meets this week.
"A continued loss of momentum across a number of key categories — slower payroll growth, a contraction in manufacturing, a pullback in consumption — not only justifies earlier action taken by the Fed, but further perpetuates the need for additional policy stimulus to stave off a continued downward trend in domestic activity," said Stifel Chief Economist Lindsey Piegza.
A rate cut will hurt bondholders, according to Marc Odo, client portfolio manager at Swan Global Investments. “If rates stay low and monetary policy remains loose, bond holders are stuck with yields that are barely enough to cover inflation,” he said. “If rates start increasing, the prices of existing bonds will fall.”
Going forward, “bonds cannot play the dual role of income and capital preservation in portfolios,” Odo said.
With low yields, lending standards have softened, with non-investment-grade borrowers turning to leveraged loans and collateralized loan obligations. “Some market watchers are raising red flags on the similarities between CLOs and the pre-2008 [mortgage-backed securities] market,” Odo added.
Factory activity in Texas expanded “at a markedly slower pace” in October, the Texas Manufacturing Outlook Survey, released Monday, showed. The production index slumped to 4.5 from 13.9 the month before, “suggesting a moderation in output growth in October.”
The new orders index fell to negative 4.2, the first time in three years it’s been below zero, while the growth rate of orders index also turned negative.
The general business activity index, which gives a broader read, also slipped to negative 5.1, following two months of positive readings.
The survey’s read of the labor market “suggested slower growth in employment and work hours.”
Expectations improved from September, as the index of future general business activity climbed to positive 2.4 from negative 6.8.
Separately, the Federal Reserve Bank of Chicago’s National Activity Index dropped to negative 0.45 in September from positive 0.15 in August, as production-related indicators declined. Negative readings suggest below-trend growth.
The three-month average CFNAI-MA3 fell to negative 0.24 in September from negative 0.06 in August, while the diffusion index slid to negative 0.25 in September from negative 0.10.
On Friday, the University of Michigan Consumer Sentiment Index’s October final read was 95.5, down from 96.0 at mid-month, though up from the final September 92.3.
The current conditions index was 113.2, down from 113.4 mid-October, but up from the final September 105.3 read, while the expectations index was at 84.2, compared with 84.8 mid-month and 79.9 in September.
The inflation indexes both fell in the month: the five-year was at 2.3% in October, off from 2.6% in September, while the one-year slid to 2.5% from 2.7%.