High Prices Good!

One of the lasting lessons learned from the financial crisis is how much better the world seems to be when asset prices are high(er). Balance sheets are strong when prices are strong. Loans look better when collateral prices are higher. As we saw in 1999 and again in 2007, higher prices make for a wonderful investor world.

Looking at the Dow Jones Industrials, the S&P 500 and the NASDAQ today, I am reminded of 1999 and 2007. High prices good! Also like 1999 and 2007, cracks are developing. *(The Dow Jones Industrial Average, S&P 500 and NASDAQ Composite are unmanaged indexes.  An investment cannot be made directly in an index).

The greatest crack that concerns me is the reversal in trend for US bond prices. From Federal Reserve Chair Janet Yellen’s perspective, we are in year seven of a zero interest rate policy. The Fed slashed interest rates to .25% to help insure low rates would result in high(er) prices. Later the Fed threw in several trillion dollars in quantitative easing for added measure. Fewer US Treasury notes and bonds in circulation along with low interest rates for an extended period of time should keep prices high also for an extended period of time. Stock investors love the narrative!

Looking more closely we see how interest rates bottomed in 2012 and have slowly been inching their way up ever since. Two year treasury notes hit their highest levels since just this past week. From .20% on July 2012 to .99% last week, these yields may be low in the eyes of stock investors, but it is the change in trend that should be of greatest concern.

Municipal bond buyers, like stock investors, don’t seem to care about rising treasury note rates. Short-term municipal interest rates appear to me to be among the lowest ever. With the two year note moving from .20% to .99%, this would make short-term municipal bonds extremely rich in price particularly over the past several years.

Take a look at the Port Neches – Groves school bonds below. With the one year yield of .53%, three years at 1.05% and four year yields at 1.21%, one has to wonder who is buying these yields and why? Perhaps municipal bond investors are reacting to the prospect of higher rates by buying short-term maturities, regardless of price (yield).

Markets are like that. Interest rates are rising (on treasury notes) but not necessarily for tax-free municipals. Interest rates are trending higher on treasury notes and bonds, but stocks don’t seem to care.

So why should you care? You have seen the stock markets sell off over 50% twice in the past fifteen years. Thankfully interest rates were trending lower and bond prices were trending higher. We may not have known it at the time but trends are easier to see in hindsight.

I believe the 2012 trend change in bond prices will also be easier to see in hindsight. Higher yields and lower prices are not good. Higher prices good…lower prices on the entire asset class of bonds is not good…at all.

The Fed would have you believe that it will determine when interest rates change, yet the two year treasury note is .99% up from .20% while the Fed has held its rate steady at .25%. The Fed did not prevent stocks from selling off over 50%, twice. Now with bond prices reversing course the risks in both stock and bond markets appear to me to be greatly elevated; hence my 1999 and 2007 reference.

I continue, despite the relative high prices and low yields in short-term municipals, to find what I believe to be worthwhile bonds. While I am disappointed many bonds are trading at high prices, I continue to find worthwhile bonds and remain optimistic, primarily because markets change. Whether municipal bonds appear to be relatively expensive as they do now, or relatively cheap, it is the direction of the trend that I believe will impact prices the most. The trend for bond prices is higher yields and lower prices and I expect the trend to continue to gather momentum in the coming months and years.

The volume of municipal bond trading is at a ten year low, according to the MSRB, with a level that is but one third of the amount of the 2007 trading volume highs. Many firms are laying off fixed income professionals in their bond departments, including municipals. I am both thankful and grateful for your support and the business that we do together. I wish you and your family the happiest of holidays this season.