Since I started “Market Musings” I have touched on stocks, commodities and foreign exchange, but, until now, have written little about what I consider to be the most influential market in the world. US Treasuries are considered to be the “risk-free” asset when financial advisors and planners calculate the forward value of an investment, giving them a vital importance to all, whether they hold them or not.
The trajectory of Government debt over the last twenty years and the dysfunction in Washington may lead many of you to question that “risk-free” designation, but investors around the globe see US Government debt as one of the safest bets there is. Thus, Treasuries are considered a safe haven; a parking place for cash in troubled times. The recent spike in yields (and therefore drop in prices) is the result of exceptional circumstances, for sure, but may still contain a message for markets in general.
The exceptional circumstances are well known. When Quantitative Easing (QE) was first announced back in November of 2008, it was designed as a program to buy primarily mortgage backed securities; Treasury bonds were added seemingly as an afterthought. Once the buying began, however, the market quickly became acclimatized to it.
The problem for market watchers became that Treasury yields lost their status as an indicator of market sentiment. Low yields were no longer a sign of impending economic trouble; they were just the inevitable consequence of there being a massive buyer of the paper always lurking in the background.
The sustained period of low rates led many analysts to claim prematurely that the 30 year bull market in bonds was over; they believed that rates just couldn’t go any lower. The Fed, however, made fools of them with QE2 and QE3. Given the history, the spike in yields following Chairman Bernanke’s hints at the end of the program are hardly surprising. There were an awful lot of nervous, pent up sellers out there.
Once again, the Fed’s distortion of the market means that this move means nothing as far as an indication of sentiment, it is just an inevitable reaction to a hint that the biggest buyer of Treasuries is going to, at least, slow down. What happens from here, however, could well give us a significant indication of market sentiment.
It is easy to forget that, for now, the bond buying program remains unchanged. If yields stay at current levels or move higher still, therefore, it would indicate significant sellers of Treasuries, beyond the knee jerk initial reaction. I believe this is likely. What was overlooked by many in the FOMC minutes and subsequent statements by Bernanke was the Fed’s overall rosy view of the economy; a picture of rising growth and falling unemployment that made possible contemplation of an end to QE.
We have become accustomed in recent years to Treasuries and stocks moving in unison as they react to sentiment about the Fed’s actions, rather than to economic fundamentals. This is not a “new normal” as some have suggested. This is a result of massive distortion of the market; distortion which we are now told is coming to an inevitable end. As things normalize, I would expect yields to continue on their upward trend, but don’t expect a “bursting bubble” kind of collapse in the bond market; more of a gradually deflating balloon, largely because of one important factor.
The Fed also decided at their last meeting to keep short term rates at historical lows and continue to pursue a Zero Interest Rate Policy (ZIRP). As long as this is the case, and it will be so long as there is no evidence of inflationary pressure, a collapse in the bond market is extremely unlikely.
There is a chance, then, that Bernanke et al will be able to pull off what, at times, looked impossible; a gradual exit from QE. As yields slowly rise, the proceeds from an orderly exit from the bond market will replace the cash forced into the stock market by the Central Bank. All of this is dependent on prices remaining relatively stable. Any shock to, for example, oil prices will derail the whole thing, as would a natural increase in inflation should the money created over the last few years start washing around the economy at a faster pace.
To return to the original question posed in the title, does this mean the 30 year bull market in bonds is over? I would say yes. If the distortions of the last few years can be removed without a significant shock to the system, then this could clear the way for a gradual increase in bond yields, and drop in prices, over the next few years. The nature of bonds makes it unlikely to be a vicious, sudden collapse, but the balloons are deflating. It would seem that the party is over.