When Good News is Bad News

Before beginning I have to take a moment to comment on the fires raging in SoCal. The pictures and stories are horrifying. All this evokes memories of our past fires in and around Sonoma County – lives and property lost, local and regional economic impacts, and lingering psychological imprints. All of that is happening down south, just more. My heart and prayers go out to everyone who has been impacted, and to the brave souls fighting the fires.

On to this week’s post…

Obviously there’s a lot going on right now so you may not have noticed the thud made by markets on Friday when, after limping into 2025, stock and bond prices sort of fell down. It wasn’t actually that bad, but it felt a little demoralizing in the context of recent returns.

Last week was one of those odd times when hearing good news is bad news. The good news was we learned our economy has been adding more jobs than expected and, at least in general, our economy is doing better than anticipated. So why would that be bad news for the financial markets? Investors had been expecting that borrowing costs would fall a lot throughout this year but those hopes are getting dashed by a resilient economy that (arguably) doesn’t need much lower interest rates and a Federal Reserve that suddenly doesn’t want to go that route anyway. So more good economic news last week just fed into this rate anxiety.

This helped the broad stock market dip its toe into oversold territory last week, based on a range of recent average prices. Stocks, as measured by the S&P 500, dropped a couple percent for the week and are down about a percent so far this year. Not a big deal all things considered, not even close to a technical market correction, but it smarts a bit after how markets ended last year. Most sectors began this week in oversold or neutral territory and that’s generally a good time to buy more. Stocks are higher as I write this Tuesday morning and managed to close with a gain yesterday as well; buyers following sellers creating normal volatility.

The bond market jumped into oversold territory with both feet, however, with the US Aggregate Bond Index dropping a percent last week. Maybe that doesn’t sound all that bad, but bonds are supposed to be safe and stable, especially when stock prices get volatile. Historically it’s appropriate to expect bond prices to be flat or maybe rise a pinch when stocks fall. However, that negative correlation shows up over a long period of time and a variety of other factors contribute to it in the short-term. The problem is that stocks and bonds have been more positively correlated since the pandemic, moving in tandem much of the time even if the amount of change isn’t the same. This relationship may eventually revert back to historical norms but certainly presents challenges in the meantime.

While the Fed may continue reducing short-term rates, the market is going in the other direction with longer-term rates. The benchmark 10yr Treasury note yielded 4.8% briefly last Friday, a level not reached since late-2023 and is over a percentage point higher than when the Fed started lowering rates last September. This helps stimulate stock market volatility and creates sort of a feedback loop here and abroad. But there’s a silver lining. Falling bond prices means interest rates/yields are higher for new purchases, either when buying individual bonds or bond funds.

At the same time, cash equivalents like money market funds have paid well but those yields have gone down as the Fed reduced rates. A quick review of Schwab’s Value Advantage Fund, Vanguard’s Cash Reserve Fund, and Fidelity’s Govt Money Market Fund show 7-day yields (a standardized indicator of what these funds are paying now) right around 4.2% compared to over 5% last year. While we don’t know how low the Fed will go with rates and how long that will take it seems clear that cash rates aren’t likely to go back up anytime soon.

While there is market risk with bonds and not with money market funds, a variety of bonds now pay more than the typical money market. I see 1yr Treasuries paying about 4.3% and Vanguard’s Total Bond Market fund has a 30-day SEC yield (another standardized metric) of about 4.6%. There’s also some upside potential with bonds and bond funds, but that’s where the market risk comes in.

The bottom line is that bonds have been underperforming but should continue to play a role in your portfolio based on your plans, risk tolerance, and so forth. Bond returns will eventually improve and we could start seeing that shift this year. So if you’ve been keeping cash in money markets in lieu of bonds or otherwise avoiding the bond market, it’s a good time to start switching gears. I favor doing so incrementally, perhaps monthly over the course of this year depending on how much money we’re talking about. Doing so could help reduce your risk somewhat while allowing for bond yields to continue to rise.

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