It is a common misconception amongst those outside the market that the stock market is king. Insiders understand that it is the bond market that really drives everything. U.S. Treasuries, in particular, are the default place to invest. Any move up in stocks can easily be seen as a move away from bonds and vice versa. An understanding of the state and fate of the bond market, then, is essential for anybody setting strategy for the New Year. If headlines are to be believed, 2013 could be the year that the “bond bubble” bursts with frightening implications for global financial markets.
I first heard talk of a bond bubble and impending disaster late in 2010, when I was working as an advisor at a major Wall Street firm. Mutual fund company reps would come around and give presentations, and the impending collapse of the overvalued bond market was a popular one at the time. U.S. 30 Yr Treasury yields were heading back towards 4% and this was seen as unsustainably low in a recovering economy. Rates were predicted to continue rising, and prices, therefore to continue falling. Flows from equities to bonds among retail investors were still strong but bonds were starting to look like a crowded room, and we were all warned that the rush to the exit would be scary. So much for that idea!
Many blame the market distortions of Quantitative Easing and “Operation Twist” for artificially low yields in Treasuries and therefore US bonds in general but, while that is undoubtedly a factor, it should be noted that long term yields were already depressed prior to any hint of action. The Fed has been determined to hold rates down, however, and seem intent on driving investors’ money to stocks. QE is ongoing and unlimited and I am on record many times as saying that a career in Foreign Exchange taught me that taking on the Fed is a mug’s game. That still applies, but as “Twist” draws to a close some upward pressure at the far end of the curve is to be expected. Combine that with the fact that the flow of retail funds to bonds has slowed and begun to show signs of reversing, and the doom mongers are out again, predicting blood on the streets.
Recent experience shows us that, no matter how bad things look for bonds logically, however, the market is remarkably resilient. Just ask Bill Gross, who bet against Treasuries in 2011. The status of U.S. Treasuries as risk free assets would seem to be in little danger despite the impending debt ceiling negotiations; last time we went through this, prices increased, despite a downgrade of U.S. debt from S&P. I believe interest rates in general will finish the year higher, and am therefore bearish on the asset class, but I am not in the bursting bubble camp. Look for a steepening of the yield curve amid generally lower bond prices.
30 Year Nominal Yield
When seen in the context of a multi-year chart, as above, the recent rally in long dated Treasuries looks a little less momentous than some would have you believe. There is still room for a gradual rise.
There is a feeling that rates must go up soon, I mean how long can they stay at historic lows? A glance at Japanese yields since the mid 1990’s shows you that they don’t have to go back up in a hurry. That said, I do believe that U.S. Treasury yields will start to recover in 2013, pushing bond prices down in general. The economic recovery is slow, but real, and I would expect that to translate to a shift in investor funds away from low yielding U.S. Government debt. The point is that it is unlikely to look like a bursting bubble; more like a deflating balloon.
The danger, of course is that those who moved to Treasuries to ensure a return of, rather than on, capital will get spooked as they see the value of their holdings falling and all rush for the exit together. This is possible, but I believe today’s 24 hour news cycle, where disaster always seems to be a few days away, will slow the pace of redemptions.
For most investors, bonds will still serve their purpose of reducing the volatility of portfolios overall, but it is hard to escape the conclusion that there are likely to be better opportunities elsewhere. Money moving out of Treasuries will be positive for stocks. Higher yields will be positive for the USD. A higher USD will put pressure on commodity prices, offsetting the increased demand from a recovering economy. Gold, which has no real demand dynamics, could well edge higher as we approach the debt ceiling fight, but will finish the year lower if the central thesis on bonds, and therefore the Dollar, is correct.
Given this relationship between bonds and everything, fear of the chaos a bursting bubble would cause are justified. Simply put, though, a period of sustained demand and high prices does not, in and of itself, make a bubble. Bond prices may correct, but not collapse. The World is not coming to an end (yet)!
Martin Tillier has been dragged, kicking and screaming, into the 21st century and can now be followed on Twitter @MartinTillier.