Why Bonds Are Up And Rates Down Despite Fed Tapering

Bond prices and interest rates have astonished investors this year by doing the very opposite of what many expected as the Federal Reserve scales back its monthly bond purchases, known as quantitative easing.

Bonds rallied -- nearly keeping pace or outperforming stocks and commodities -- as interest rates tumbled. Bond prices and yields move in opposite directions. Benchmark 10-year Treasury yields have tumbled 44 basis points, from 3.04% at the start of the year to 2.60% as of June 3.

"The markets always do what frustrates the greatest number of participants," Charlie Smith, chief investment officer at Fort Pitt Capital Group in Pittsburgh, said. "In late 2013, sentiment was overwhelmingly negative on bonds, so they rallied."

Vanguard Total Bond Market ETF ( BND ), the largest of its kind with nearly $20 billion in assets, has returned 3% year to date. It slipped 1% from its 52-week high after a four-day slide, but has held above its 10-week moving average. SPDR S&P 500 ( SPY ), meanwhile, is up 5% this year.

IShares MSCI EAFE Index ( EFA ), tracking developed foreign markets, andiShares MSCI Emerging Markets Index ( EEM ) are also up about 3% this year.

The longer the bonds have until maturity the more sensitive their prices are to interest rate changes.IShares 20+ Year Treasury Bond ( TLT ), which holds bonds with 20 to 30 years until maturity, appreciated an eye-popping 11% year to date, even after the recent slide. It has regained nearly all of its losses from 2013, when it lost 13% and interest rates rose more than 1% during the year.

All other types of fixed-income ETFs have posted positive returns this year, includingiShares iBoxx $ Investment Grade Corporate Bond (LQD) up about 5% year to date,iShares iBoxx $ High Yield Corporate Bond (HYG) 4%,SPDR Barclays International Treasury Bond (BWX) 4%,iShares National AMT-Free Muni Bond (MUB) 6% andPowerShares Preferred (PGX) 11%.

Confluence Of Forces

"Limited supply of Treasuries as the budget deficit declines, with increasing demand for the world's safest security, combined with very low inflation rates and low rates throughout the developed world, all are more important and longer lasting influences on rates than the Fed actions," Margie Patel, who manages more than $1 billion at San Francisco-headquartered Wells Capital Management, said in an email.

The menu for risk-free returns is shorter than ever, making U.S. Treasuries the prettiest house in an ugly neighborhood. Interest rates in the world's largest developed economies -- Japan, Germany, France, the U.K. and Canada -- range from 0% (Japan) to 1% (Canada) vs. 0.25% for the U.S.

"The biggest mistake an investor could make today is expecting interest rates to move up materially in the second half of the year, and that soon, rates will be back to 'normal' levels, and back to where they were before the 2008 financial crisis," Patel added.

Falling interest rates, which go hand in hand with heavy demand for safe-haven bonds, reflect weak economic growth and perhaps the stock market's expectations for more weakness ahead globally.

The economic recovery since 2009 has merely been a short-term rise within a long-term depression, says economist David Levy of the Jerome Levy Forecasting Center.

In a report released May 29, Levy wrote the next global downturn will be fueled in part by 1) The euro area's failure to recapitalize its banks and force them to write off bad debt; 2) The euro area's failure to develop a single-borrower structure for sovereign debt markets; and 3) China's enormous debt expansion and unsustainable economic growth rate.

Yields on benchmark 10-year Treasuries will likely dive below 1% in 2015 or 2016 and the Fed will keep the policy rate near zero until 2020, Levy contends.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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