The Lato Letter: Volume 1, Issue 9.

The Lato Letter: Volume 1, Issue 9.

Markets have been very strong since the last Lato Letter on generally more favourable economic statistics out of the US, and a fairly clean bill of health for US financial institutions following the release of the Federal Reserve’s stress tests earlier this week.  In conjunction with rising stock prices, we have also seen rising bond yields (and falling bond prices) over the last week.

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Chart courtesy of Bespoke Investment Group/Raymond James & Associates

Generally, low interest rates are better for stocks than high interest rates but that is a very broad statement that often has exceptions, particularly over short to medium term periods.  The rise in long bond yields could be signaling a further strengthening in the US economy as yield spreads between short term rates (Treasury bills) and bond yields have begun to widen.  Rates remain at generational lows and so the initial increases in yields from these very low levels should not have a great impact on stock valuations.

In fact, a steepening yield curve (a greater spread between long bond yields and short term interest rates) is generally positive for stocks since that condition is prevalent during periods of accommodative monetary policy and expected growth in the economy.  The danger to stocks occurs when all interest rates become significantly higher or the yield curve “inverts” (short rates exceed bond yields) signaling the condition that monetary authorities like the Federal Reserve or Bank of Canada are seeking to slow the growth of the economy.

At Padlock, we take a passive approach to the fixed income side of balanced accounts.  A client’s fixed income allocation, as determined by their Investment Policy Statement, is placed in a “ladder” of maturities ranging between six months and five years.   This approach is briefly discussed on the Portfolio page of the Padlock website.  With the thus far flat yield curve and overall low level of interest rates, the ladders have been skewed to even shorter maturities until an opportunity to lock in slightly higher yields on five year bonds materializes.

I realize that there has been a lot of investment jargon in this letter so if you are not clear about any of the terms or the message, please give me a call and I would be pleased to discuss it with you.

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