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Last weekend I wrote, Will Bond Vigilantes Drive The 10-Year Above 2.06% After Confusing Fed-Speak? The answer was a resounding "Yes!" as the yield on the 10-year Treasury rose to 2.14% (and prices dropped). Other parts of the bond market cracked as well, including TIPS, Japanese bonds and mortgage bonds. Junk (or High Yield) bonds may soon follow. These cracks are still mild, but it is important to follow them closely because selling begets selling. I am currently bearish on bonds and believe that there is more weakness to come. Equities are also vulnerable, especially stocks that attract income oriented investors. In this article I will look at the dynamics of Federal Reserve policy that are causing weakness in bonds. I will also look at the price action in each of these markets and discuss the relationship between them.

Federal Reserve Policy

The Federal Reserve's current quantitative easing program (QE Infinity) has been in place since December 12, 2012. QE Infinity consists of $85 billion of monthly bond purchases ($45 billion of longer-term Treasury bonds and $40 billion of mortgage bonds).

This program was designed to help the economy in a few ways. The purchase of Treasury bonds was intended to drive down yields (yields and price move in opposite directions). Low yields help reduce borrowing costs across the economy.

Furthermore, low yields on Treasury bonds would incentivize investors to put their money into riskier assets, like stocks (and also junk bonds). This would drive up stock prices and create a wealth effect leading to more consumption and economic activity.

Additionally, the purchase of bonds is the Fed's way of printing money and adding liquidity to the system.

The purchase of mortgage bonds was more specifically directed at lowering mortgage rates to incentivize people to buy homes and boost the housing recovery.

All good things come to an end and the Fed has started to discuss reducing, or tapering, the $85 billion of monthly bond purchases.

Ben Bernanke discussed the potential for tapering in his testimony before Congress recently. There is a healthy debate at the Fed about when to taper and it could happen at an upcoming meeting. Furthermore, Bernanke reiterated that the decision to taper is "data dependent" meaning that the Fed will consider tapering when it sees better economic data. He did not clarify what data would make him support tapering. Please see my article from last week for more analysis of Bernanke's recent comments.

The next Fed meeting is June 18-19, so mark your calendars. Until then, the bond market will be trading on speculation of the Fed tapering. A key datapoint will be the May nonfarm payroll report that will be released on Friday, June 7. Good data would increase the probability of tapering, which could actually drive the bond market lower (and yields higher). Stocks would likely fall in such a scenario as well.

In the next few sections, I will look at the dynamics in the bond markets. At the end of the article, I will return to Fed policy and discuss the upcoming Fed meeting.

Treasury Bonds

Yields on Treasury bonds have been falling (and prices rising), despite the Fed's $45 billion of monthly purchases. The Fed cannot reduce yields, but it may be keeping yields lower than they would otherwise be without Fed intervention.

The following graphs give perspective on the yield 10-year Treasury bond over different timeframes. Please remember that yield moves in the opposite direction of price.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

The first graph shows that over the last few decades, the yield on the 10-year Treasury has dropped significantly (as prices moved up), but there is not much more room for the yield to fall further.

The second graph shows that the 10-year Treasury reached its low point in terms of yield last summer and has been rising ever since.

The third graph shows the yield on the 10-year has been rising (and price falling) since December 12, 2012, despite the Fed's current QE program. The 10-year's yield has now jumped to its highest level in over a year.

It is important to pay special attention to the price action since May 9, 2013, when the debate about tapering became more intense as The Wall Street Journal published an article about the Fed's intentions: Fed Maps Exit From Stimulus (the article appeared on May 11, but rumors about it started to emerge on May 9).

Clearly, the debate about tapering was the catalyst for the recent fast and furious move up bond yields (and drop in prices).

This is the first crack to note in bond markets.

The following shows the price action for the iShares 20+ Year Treasury Bond ETF (TLT), which is a common proxy for Treasury bond prices. It moves in the opposite direction of the yields shown above.

(click to enlarge)

(Source: FreeStockCharts.com)

The dynamics on the 10-year Treasury have a direct impact on the prices of other bonds and, arguably, stocks. The yields on Treasury bonds are considered to be the "risk free rate," since the risk of the U.S. defaulting on its obligations to pay bondholders is relatively low.

Other bonds are priced relative to the risk-free rate. The difference in yields between riskier bonds and Treasury bonds is called the spread. The spread can expand or contract depending on how the market prices riskier bonds. I will discuss this further in the section below about high yield bonds.

Treasury Inflation Protected Securities [TIPS]

TIPS are Treasury bonds that are designed to compensate the bond holder for increases in inflation. Generally, TIPS are more attractive if investors think inflation will be higher in the future.

Yields on 10-year TIPS have been negative for a while. However, recently, the yield on 10-year TIPS has moved closer to zero, as the price on 10-year TIPS has dropped.

The following graph shows the yield on 10-year TIPS:

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

The iShares Barclays TIPS Bond Fund ETF (TIP) tracks the price movements of TIPS and is designed to move in the opposite direction of the yield on TIPS, shown above.

(click to enlarge)

(Source: FreeStockCharts.com)

Some may argue that the sell-off in TIPS (and the higher yields) is a result of a change in inflation expectations.

However, the size and speed of the move seems to suggest that the TIPS market is moving in tandem with regular Treasury bonds and is part of a larger sell-off.

This is the second crack worth noting.

Japanese Bonds

The sell-off in bonds (and increase in yields), is not limited to the U.S.

The following graphs show the yield on the 10-year Japanese Government Bond over the last five years and last twelve months.

(click to enlarge)

(Source: Bloomberg.com)

Over many years, the trend has been for lower yields (and higher prices). However, since April, the opposite has occurred.

The dynamics in Japan are not the same as in the U.S. Japan recently launched its own QE program, which has a different impact on its bond market. However, I believe that Japan faces higher bond rates whether or not its QE program is successful. A continued sell-off in Japanese bonds (and higher yields) is another reason for global bond investors to be cautious.

The Japanese bond market is the third crack.

Other Global Bond Markets

Bonds in Germany and the UK haven't cracked in the same way as in the U.S. and Japan. Yields on bonds in Germany and the UK have moved up recently (as bond prices dropped), but they have not broken their prevailing trends. It will be important to watch these markets as well.

Mortgage Bonds

Mortgage-backed securities are showing weakness and seemed to have cracked.

The iShares MBS Bond ETF (MBB) invests in investment grade agency mortgage backed securities. The price action of the MBB is a proxy for the price of mortgage backed securities.

(click to enlarge)

(Source: FreeStockCharts.com)

This is the fourth bond market to crack.

High Yield (Junk) Bonds

Junk bonds represent the riskiest part of the corporate bond spectrum. Please see the appendix for more information about the ratings of junk bonds.

Below are graphs of benchmark yields on bonds rated BB, B and CCC (CCC bonds are the most risky).

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

Over the last year, these yields declined significantly (and prices jumped). But the opposite occurred over the last few weeks. It is too early to determine if these markets cracked, too.

It is also important to look at the spreads for junk bonds, which are the difference between the yields on junk bonds and Treasury bonds. As seen in the graphs below, spreads have been decreasing over the last few months.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

The junk bond market is vulnerable for two reasons.

First, yields on junk bonds are at record lows and do not seem sustainable. If yields move up, then prices will drop.

Second, spreads between junk bonds and Treasury bonds are very low (though not at all time lows). Therefore, if Treasury bond yields move up (and prices down), the junk bonds will probably follow. Otherwise, the spread would narrow even more and there is little room for such a move.

The following graphs show the price action for two widely watched junk bond ETFs: SPDR Barclays Capital High Yield Bnd ETF (JNK) and iShares iBoxx $ High Yield Corp Bond ETF (HYG). These ETFs track the prices of junk bonds, which move in the opposite direction of the yields shown above. These graphs show some signs of recent weakness.

(click to enlarge)

(Source: FreeStockCharts.com)

Impact On Equities

The sell-off in bonds is already having an impact on some parts of the equity market.

Investors in utilities and real estate investment trusts (REITs) are generally income oriented investors that are attracted to those kind of stocks because of their high yields. However, higher bond yields make those sectors relatively less attractive. With higher bond yields, stock prices need to move lower to attract new investors.

The Utilities Select Sector SPDR® Fund (XLU) is already down ~10% from its high at the end of April.

(click to enlarge)

(Source: FreeStockCharts.com)

Similarly, the iShares U.S. Real Estate ETF (IYR) is down ~9% from its recent high.

(click to enlarge)

(Source: FreeStockCharts.com)

The consumer staples sector has recently become an area of interest for income oriented investors. It too is showing signs of weakness, as tracked by the Consumer Staples Select Sector SPDR® Fund ETF (XLP):

(click to enlarge)

(Source: FreeStockCharts.com)

These sectors had been leaders in the rally of the S&P 500 (SPY) until recently. The S&P 500 ended the week on a down note and may face further weakness as the selling begets more selling.

(click to enlarge)

(Source: FreeStockCharts.com)

Thoughts On The Fed's Upcoming Meeting

The Fed's public deliberations about tapering introduced a lot of confusion into the market. This will likely continue until, at least, the Fed's next meeting on June 18-19. The market has a long time to trade on speculation alone, which is dangerous.

The release of the May nonfarm payroll report will also add more fuel to the fire.

I don't expect the Fed to taper at the June meeting. However, the tapering discussion is on the table and will not go away.

The problem is that there is little that the Fed can do to ease the concerns of bond investors. The best outcome for bond bulls would be if the Fed gave more clarity about what kind of economic information would lead it to taper and do so in a way that makes it seem like the economy will not produce such conditions for a few more months. Unfortunately, I think the likelihood of this outcome is low.

The Fed will probably continue to say that it is looking at the data and will start to taper when the economy improves.

A Few Twists

It is important to remember that Ben Bernanke could cause the bond market to reverse course at any time.

If Bernanke wants to reduce bond yields, he can always come out with a statement that implies that tapering will not happen for a while. Furthermore, the Fed could also increase its monthly bond purchases. Low inflation gives the Fed a lot of leeway if it wants to use it.

Another twist is that a sell-off in junk bonds and equities may attract investors back into Treasury bonds, which may be perceived as a safe haven. During the crisis points of the last few years, we have seen this rotation a few times. We'll see if investors still consider Treasury bonds a safe haven in a sell-off that was caused by weakness in those bonds.

If yields on Treasury bonds rise high enough, they will likely attract certain investors, especially insurance companies and pension funds. This could create a ceiling for Treasury bond yields in the short term, but it is not clear at what level.

I would not be surprised to see a sell-off in Treasury bonds lead to a sell-off in riskier parts of the market, such as junk bonds and stocks, and then capital would rotate back into Treasury bonds as investors look for a safe haven and lock in higher yields.

Conclusions and Outlook

As long at the 10-year Treasury stays above 2.06%, my operating thesis is that we will see further weakness.

Four parts of the bond market already cracked: Treasury bonds, TIPS, Japanese bonds and mortgage bonds. There are different dynamics in each of these markets, but selling begets selling. Furthermore, until the Fed meeting on June 18-19, there is a long period for the markets to trade on speculation alone, which is dangerous.

The junk bond market looks like the next bond market to crack.

Equities are also vulnerable, and some sectors in the equity market have already experienced declines.

Although I expect further weakness, it is important to recognize that the Fed could cause the market to turn on a dime. This is a low probability scenario now, but it may become more relevant if Treasury yields move up too much too fast. Things can change at any time, so I will keep an open mind and may change my operating thesis if the dynamics change.

For the sake of full disclosure, I am short Treasury bonds through the ProShares Short 20+ Year Treasury ETF (TBF). I am also long put options on the TLT and JNK that stand to gain in value if these ETFs decline in value. I am long put options on the SPY that stand to gain in value if the SPY declines in value. I am also long the ProShares Short S&P 500 ETF (SH), ProShares Short Russell 2000 ETF (RWM) and ProShares Short QQQ ETF (PSQ). The SH, RWM and PSQ stand to gain in value if the S&P 500, Russell 2000 and Nasdaq 100 decline in value. I am also long call options on the VIX (VXX) that stand to gain in value with increased volatility. Despite the short positions on bonds and the main equity indices, I am still long individual stocks and have a net long portfolio. This is not investment advice. I only mention this for the sake of full disclosure.

Appendix

(click to enlarge)

(Source: Wikipedia)

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Source: Selling Begets Selling: 4 Bond Market Cracks Threaten Rally In Risk Assets

Additional disclosure: I am short Treasury bonds through the ProShares Short 20+ Year Treasury ETF (TBF). I am also long put options on the TLT and JNK that stand to gain in value if these ETFs decline in value. I am long put options on the SPY that stand to gain in value if the SPY declines in value. I am also long the ProShares Short S&P 500 ETF (SH), ProShares Short Russell 2000 ETF (RWM) and ProShares Short QQQ ETF (PSQ). The SH, RWM and PSQ stand to gain in value if the S&P 500, Russell 2000 and Nasdaq 100 decline in value. I am also long call options on the VIX (VXX) that stand to gain in value with increased volatility.