MARKETS & ECONOMY

Bonds: Calm before the storm?JULY 18, 2014

Vanguard Perspectives®

Catherine Gordon: Interest rates remain very low by historical standards and bond market volatility is

also extremely low. Joe and Roger, with the economy continuing to grow do you think the bond market

is overly complacent or is it telling us something we should be paying attention to?

Roger Aliaga-Díaz: It's really not about the whole global market, but clearly there are segments in

which you can see credit spreads and risk spreads that are tight, especially compared to history. You

see also [low] volatility, of course, as you mention, of interest rates and also of equity markets, [and]

riskier assets in general, so that is concerning. I don't know if this really [is] the market or . . . the way

investors are deciphering the code words that the Fed is trying to use in terms of forward guidance.

The Fed has been trying to be transparent and trying to give as much information as possible, and

investors tend to take that information too literally sometimes, and that's why the Fed is reminding

investors that it's really data-dependent. So, information the Fed gives depends on how they see the

world right now, but as data change, they will change their view. Investors tend to think that the

predictions of the Fed . . . are almost certain, and that could bring a little bit of sense of complacency

to markets that we are watching closely.

Joe Davis: All the volatility, as Roger points out, is extremely low and it could persist although history shows that it

rarely persists for long. And so you know historically unexpected shocks on the economy with the

policy front could jar volatility higher for a time. I mean one area that we contemplate potentially is that

there is a growing risk that either because of a combination of decent job growth going forward in the

United States as well as still-weak labor force participation—those Americans that perhaps have

dropped out of the labor force [and] come back in—if they don't come back at such a vigorous pace,

the unemployment rate, before the end of the year, could be below 6%, which is not in the Federal

Reserve's projections.

That would change the conversation; so again, I would say returns over the past several years have been extremely

strong. But if you look at low levels of volatility, they're commensurate with compressed risk premiums. But I think it's

an outlook where the stronger the returns more recently have been I think the lower the expected future returns we

should have. And so I think at the margin investors should at least reassess before taking more aggressive risk

positions because investors have been rewarded, [and] they are unlikely to be rewarded to the same extent going

forward.

Catherine Gordon: Thank you.

Disclosures

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