The bond bubble has burst and the 30-year bull market in bonds is finally over. Or so it would seem based on the flood of recent commentary from the financial media and press. While it has certainly been a most difficult stretch for bonds since the beginning of May, it is still far too premature to declare that the end is finally upon us for the bond market.
Don't get me wrong. I'm not suggesting that bonds represent an attractive long-term buy-and-hold investment the way they have for the past 30 years. With interest rates having already fallen to historic lows, the scope is limited for interest rates to fall much further. But this does not mean that rates are poised to immediately explode higher, either. After all, Treasury yields still remain in their long-term downward sloping trend that began all the way back in late 1981. In fact, they are still in a new lower trading channel that emerged immediately following the outbreak of the financial crisis.
Thus, the declaration that the long-term bull market in bonds is over is hasty. Of course, today is not the first time that we have heard that the bond market is meeting its demise, as the post crisis landscape is littered with dire predictions on bonds that ended up missing the target as yields continued to fall. The following are just a few examples:
"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."
-Berkshire Hathaway 2008 Annual Report
"This bubble may be the biggest one of them all. The Treasury bubble is about to burst."
-MarketWatch, November 2, 2009
"The bond market is in a bubble. And it's getting ready to burst."
-Money Magazine, June 4, 2010
"Gross was right: The bond bubble will burst."
-MarketWatch, October 18, 2011
"Signs indicate that Treasuries could be a bubble about to burst"
-USA Today, June 12, 2012
So the calls going out in recent days that the bond bubble is about to burst are certainly nothing new. Certainly, at some point Treasury yields will finally rise from their historically low levels. And perhaps the widespread calls will be correct this time, but far more evidence will be required to officially declare the bond market dead. Thus, it is worth exploring in more detail exactly what is going on in the bond market today and whether it is truly signaling that a major prolonged shift to the downside is imminent.
Putting Today's Treasury Yields In Context
Certainly, it has been a difficult road for bonds since the beginning of May. But it is important to put the recent pullback into its proper context. Yes, the last six weeks have been dreadful for bonds, but what is almost never mentioned is that the previous eight weeks were almost equally as tremendous. After peaking at 2.09% on March 8, 10-year U.S. Treasury yields declined by nearly 50 basis points to 1.61% by May 1. Thus, the fact that 10-year U.S. Treasury yields have risen to 2.23% today is hardly a catastrophic move. Sure, it's a big move from May 1, but it only represents a 14 basis point increase from where we were three months ago.
It is also worth noting where Treasury yields have been over the last few days. On the day before the release of the latest monthly U.S. employment report on Thursday, June 6, the 10-year U.S. Treasury yields had fallen back to 1.99%. And in the moments leading up to the release of the report at 8:30 AM on Friday morning June 7, these same yields were still at 2.04%. It was only after what was a generally lackluster employment report from an economic perspective that yields suddenly burst higher. I know attention spans have become alarmingly short in today's Twitter driven society, but I'm not inclined to declare the end of a 30 year trend based in part on a knee jerk market response that took place a few days ago. After all, if the jobs report turned out to be a disappointment, we could have just as easily seen yields break back below 2%.
Treasury yields also remain in the better half of their post crisis trading range and have well tested support at current levels. In the aftermath of the financial crisis from late 2008 to mid 2011, 10-Year U.S. Treasury yields were trading in a range between 2.40% and 4.00%. It was not until the summer of 2011 when yields decisively broke below the 2.40% range en route to below 1.40% by the summer of 2012. Along the way, yields have successfully tested the 2.40% level twice before returning lower.
Now, many might claim that these low yields would not have been achieved without daily U.S. Treasury purchases as part of the U.S. Federal Reserve's QE stimulus programs. To the contrary, history has shown that the exact opposite has been true, as lower yields have been reached despite these Fed bond purchase programs. For when the Fed has actually been buying Treasuries, yields have risen as institutions have been emboldened to take on more risk and more capital on net has moved out of bonds in favor of stocks during these periods.
But once these programs have ended, these same institutions find themselves clamoring back for the safety of Treasuries, more than offsetting the loss of demand from the Fed. And it was not until the Fed stopped purchasing Treasuries in the summer of 2011 that yields finally broke into their lower trading channel. Thus, for those worried that the potential Fed tapering of their bond purchase program may bode poorly for bonds, they may be upside down in their thinking, for recent history has shown the exact opposite to be true. And one has to look no further than Japan today to see clearly how the aggressive purchase of government bonds by the central bank can wreak havoc on bond yields and send them entirely in the wrong direction.
Something Does Seem Different This Time
Just because bonds are still trading well within reasonable ranges does not mean that recent trends are not a cause for concern. Thus, closer scrutiny is worthwhile to determine if we are on the brink of a major breakdown in bonds or if the latest price action is simply just noise.
First, it should be noted that some notable technical damage has been sustained on the price charts of the major investment grade fixed income exchange traded funds.
Most notably, for the first time since the outbreak of the financial crisis, the composite iShares Core Total U.S. Bond Market ETF (AGG) has broken below its 200-day moving average.
The downside price pressure has been widespread. Investment grade corporate bonds as measured by the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) have also broken this critical support level for the first time since early 2009.
In lockstep with the sharp spike in mortgage rates in recent weeks, the iShares MBS Fixed-Rate Bond ETF (MBB) has also broken decisively to the downside.
Perhaps most notable has been the sharp drop in U.S. Treasury Inflation Protected Securities, or TIPS, which have plunged swiftly lower in recent weeks on the iShares TIPS Bond ETF (TIP) to levels that are now well below recent support.
Of course, we have seen the U.S. stock market as measured by the S&P 500 Index (SPY) break decisively below its 200-day moving average on a few different occasions during the post crisis period only to eventually claw their way back higher, so these recent breakdowns do not necessarily mean that all is now lost for bonds.
But with this being said, it has not simply been a garden variety bond market pullback in recent weeks, as something more pronounced is clearly taking place beneath the surface this time around that warrants closer examination to determine if it marks the beginning of a sustainable trend or if the recent movements are just fleeting noise.
Dissecting The Recent Sell Off
A variety of suggestions have been put forth in trying to explain exactly why bond yields have been backing up in recent weeks.
Growth: One idea is that optimism over economic growth has finally compelled investors to move out of bonds and take on more risk. This proposition is flawed for several reasons. First, what exactly took place on the economic front in early May that would have suddenly sparked this notion among bond investors? They have had more than four years since the aftermath of the financial crisis to make this shift, so why suddenly would they be reacting now? And when examining the data, one could easily contend that the economic outlook is becoming increasingly uncertain, particularly with much of the rest of the world already slowing if not already in recession. Moreover, if this were indeed a shift driven by increasing optimism over the economic outlook, we would expect to see stocks thriving as bonds suffer. But following an initial charge by stocks in early May, bonds have actually been marginally outperforming stocks over the last three weeks despite all of the recent bond market woes.
Taking this point one step further, one would particularly expect to see the economically sensitive cyclicals such as Caterpillar (CAT) and Freeport McMoRan (FCX) really jumping if this were the case. Yet both of these names have been trailing the bond market since bonds began pulling back several weeks ago.
Inflation: Another theme that has been suggested is that bonds are selling off over concerns about inflation. But according to the Bureau of Labor Statistics and the U.S. Federal Reserve, inflation pressures remain under control. If anything, pricing pressures are headed more in the disinflationary direction over the last year according to the official data. Taking this a step further, recent economic data has shown a net increase in inventories in recent months, which runs contrary to any notions about an inflationary build in pent up demand.
Moreover, the velocity of money remains anemic, which is also helping to keep official inflationary readings firmly contained.
Lastly, if the sell off in bonds truly were driven by inflation concerns, one would reasonably expect TIPS to outperform nominal bonds as investors seek to establish inflation protection in their bond portfolios. But the exact opposite has been consistently true, as TIPS have been hemorrhaging relative to nominal bonds for the entire duration of the bond sell-off since early May. And when reflecting back to early May, no major inflationary shock event occurred that would suddenly change the perception about aggregate future prices going forward either.
Tapering: The recent sell off is not about the Fed potentially scaling back its bond purchases in the coming months. Or at least it should not be in part for the reasons previously discussed in this article. And if it is, it will likely present a particularly attractive buying opportunity for investors following any related sell off.
So if it's not enthusiasm over economic growth, it's not concerns about inflation and it's not related to the prospect of the Fed tapering its stimulus program, exactly what is it then? To find out, it is worthwhile to take a look back on the calendar to exactly when the sell off began in earnest.
Basically, the bond market as measured by the AGG peaked on May 2. And the sell off quickly picked up speed only a few days later. Since that time, the core bond market has traded low on 19 out of the last 28 trading days, a notable two-thirds of the time. Clearly, a specific underlying instability exists that would cause the bond market to decline so persistently over this time period. In short, it smells like forced liquidation. And the source for this selling is most likely Japan.
Japan: After enduring an initial bout of wild volatility following the launch of the Bank of Japan's (BOJ) ultra aggressive monetary stimulus program in early April, the Japanese bond market exploded starting on May 7, which just so happens to effectively coincide with the peak of the U.S. bond market. And since that time, the rise in Japanese bond yields have shared a high correlation with the decline in the U.S. bond market.
So what might be occurring in the Japanese bond market that is causing the spillover effect into U.S. bonds? While a variety of reasons could be cited, it is likely due to the implications associated with the Value at Risk (VAR) modeling approach used by many Japanese financial institutions that have massive holdings in Japanese government bonds. This is a topic that I recently discussed in the comment section of one of my recent articles. Over the last several years as the Japanese bond market volatility was relatively low, many Japanese banks were compelled to increase their allocations to Japanese government bonds in working toward a more stable VaR.
But following the launch of the BOJ's stimulus program in early April, the implied volatility associated with these bonds has exploded with concentrated spikes in interest rates on several occasions since. This sudden increase in Japanese government bond market volatility effectively forces institutions to sell these bonds in order to stay within their VaR model limits. Such selling can lead to even more implied volatility, however, which can force additional bond selling and result in a nasty feedback loop. So in order to protect against this outcome since many institutions hold massive quantities of Japanese government bonds, they can potentially opt instead to sell other assets to raise liquidity in order to offset the increased margin requirement associated with continuing to hold these Japanese government bond positions at higher volatility levels. And some of the highly liquid holdings that are likely on the list for sale is the broad range of U.S. Treasury and related investment grade fixed income securities.
This leads to an important related point. Liquidation pressures associated with Japanese bond market volatility first surfaced in the precious metals market including gold (GLD) and silver (SLV) back in mid April and subsequently spread to the U.S. bond market in early May. Thus, the next logical destination for liquidation pressures is the U.S. stock market, which is a risk that must be evaluated carefully by investors in the coming days.
In fact, this liquidation process may have already gotten underway on May 22. Only time will tell, but if the S&P 500 Index breaks decisively below its 50-day moving average on which it is currently perched at around 1610, the subsequent downside in stocks could be swift and severe. Thus, concentrating stock portfolios in high quality names such as ExxonMobil (XOM), McDonald's (MCD) and Utilities (XLU) that have demonstrated the ability to better withstand broader market selling pressure may prove particularly prudent if such a break were to occur.
Bottom Line For Bonds
If Japan is indeed the root cause of why the U.S. bond market has been selling off so hard in recent weeks, it raises the obvious question. That is, should investors react and sell amid this liquidation? The answer is no unless your time horizon is short or your risk tolerance is sufficiently low that recent volatility is no longer compatible with your personal profile. Otherwise, opting to sell in the midst of a liquidation phase is typically not good timing, as such phases often imply that securities are being sold indiscriminately and without regard to their underlying fundamental appeal. It should be noted, however, that depending on the pace and magnitude of the decline, sometimes it is prudent to stand aside from a position to wait until the selling pressure has subsided. For such phases often offer in their aftermath particularly good buying opportunities.
To briefly highlight this point, one can recall the experience of U.S. TIPS not long after the outbreak of the financial crisis. In the aftermath of the Lehman bankruptcy, TIPS were sold off violently by over 14% in a matter of just two short months. This decline had nothing to do with concerns over the creditworthiness of the United States government, as nominal U.S. Treasuries held steady and eventually took off like a rocket toward the end of 2008. Instead, the decline came about because Lehman Brothers was supposedly a major holder of TIPS and was forced to liquidate their massive supply into the marketplace. Of course, TIPS quickly bounced back once the liquidation pressure finally ended, and the pullback represented a particularly attractive buying opportunity for those at the ready.
Returning to today and looking ahead, the broader outlook for bonds remains solid despite recent pressure. For until we see sustainable economic growth and renewed stability in global investment markets, and for as long as deflationary risks continue to outweigh inflationary pressures, the demand for high quality bonds issued in the United States is likely to remain strong. One caveat to this point should be presented, however. If the Fed were to actually lose control of the bond market and yields began spiraling higher, then all bets are off including stocks and bonds. Otherwise, bonds have the strong potential to find their footing following this recently difficult period even though it may take some time to fully play out.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.