This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
The Federal Reserve left the benchmark overnight lending rate unchanged at its meeting in June. However, the Fed upgraded its assessment of the economy in light of the alleviation of transitory factors that weighed on growth in the first quarter.
That puts a possible September rate hike squarely on the table, which seems to be the consensus view. In a speech to the Greater Providence Chamber of Commerce, Fed Chair Janet Yellen said that the pace of increases will be gradual and that it will take several years for rates to normalize.
Here is some of Yellen’s speech, verbatim: “If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, though, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.”
Yellen acknowledged recent economic sluggishness but said that the first-quarter slowdown was largely transitory and that she expects U.S. economic data will improve. The economy declined 0.2 percent in the first quarter, but it appears to be tracking better than 2.0 percent growth in the second quarter. More to the point, signs are pointing to a strong second half.
All this is by way of saying it’s not a question of “if” but rather “when” the Fed will start raising rates. And by extension, investors need to take measure of the challenges ahead. Those include liquidity issues in the bond markets and whether bond funds such as the iShares iBoxx $ High Yield (HYG | B-64) will add to those challenges or help investors overcome them.
But before plunging into the ETF angle, let’s examine the contemporary bond market and the way it differs from before the financial crisis.
First, given the degree to which the Fed is telegraphing its next move, market participants are growing more concerned with the specter of rate hikes, liquidity concerns and increased bond market volatility.
Several factors, including dwindling dealer positionsand the large holding of bonds by the Federal Reserve, have us watching closely to see if any stress develops in the credit markets that could result in heightened volatility.
All is fine on that front currently, but when the market comes under stress, liquidity concerns may intensify due to regulations, including those mandated under the Dodd-Frank Act such as the Volcker Rule. Not least, there’s been a reduction in dealer risk-taking in the years since the financial crisis.
Declining Dealer Inventories
Of great concern is the fact that dealer positions have declined noticeably since before the financial crisis. In particular, dealer positions in corporate securities have seen the biggest decrease, plummeting 90 percent from its peak in 2007, from $286 billion before the financial crisis to $23 billion now, according to data from Ned Davis Research.