By John Nyaradi
On April 29, bond guru Bill Gross of PMICO sent a message on Twitter stating that the thirty-year bull in the bond market in bonds “likely ended”. Not long afterward, Dallas Federal Reserve President Richard Fisher made a similar remark to reporters, immediately after delivering a speech in Toronto on June 4.
From the “easy money” days of Alan Greenspan’s tenure as Federal Reserve Chair, through the various quantitative easing programs of the Bernanke era, United States Treasury securities (NYSEARCA:TLT) have enjoyed a unique, “safe haven” status. Now that the quantitative easing program is about to be phased out, with the Fed “tapering” its bond purchases on a gradual basis until it stops them altogether in mid-2014, many are concerned about the wisdom of investing in Treasuries. With an extra $45 billion per month slack left in the Treasury bond market, will private investors be there to pick it up, while believing that demand will persist?
Another factor to keep in mind is that as the nation’s economy strengthens, bond prices go down (and yields go up). In the pre-QE era, low bond yields were a sign of a weak economy. For the past five years, low bond yields meant that the Fed had its liquidity pump running, sending the stock market ever higher. Now that the economy might really be starting to strengthen, the negative impact on bond prices will be taking place at the very time when the Fed will be cutting back its bond-buying by untold billions of dollars per month. Beyond that, once the economy actually becomes robust, the Fed will be mindful of keeping inflation under control. Their means for doing that is by raising interest rates.
Despite the groaning when the ten-year Treasury note (NYSEARCA:IEF) jumped to 2.32 percent on June 19, many investors have already forgotten that before the financial crisis, the ten-year Treasury yield was just above 5 percent. During the early years of the Reagan administration, the ten-year yield rose above 14 percent.
The primary fear concerning elevated bond yields is the increased cost to taxpayers for paying-off the nation’s debt. We saw this unfold in an exaggerated basis in Europe.
We are already hearing about the consequences higher yields pose for the fragile housing market. Mortgage rates will go up and people won’t buy. People with investments in bond funds will see their balances fall as yields increase. Long-term bonds, such as the 30-year, are harder hit by rising current interest rates. The other side of that picture concerns the Fed’s intent to continue its near-zero interest rate policy (ZIRP) long after its bond-buying operation ends. Keeping the federal funds rate down will help subdue long-term bond yields.
Because the long-term bond market is more at risk for losing value than shorter-term Treasury notes, investors may choose to change their investments from long-term bond funds to shorter-term funds.
With all of the excitement and volatility in the bond market, investors can now consider positions should the bond bull really die:
ProShares UltraShort 20+ Year Treasury Bond ETF (NYSEARCA:TBT) – This ETF is designed to obtain investment results which correspond to twice the inverse (-2x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index. The fund invests in derivatives that ProShares Advisors believes, in combination, should have similar daily return characteristics as twice the inverse (-2x) of the daily return of the Barclays U.S. 20+ Year Treasury Bond Index.
ProShares Short High-Yield ETF (NYSEARCA:SJB) – This ETF is designed to obtain investment results which correspond to the inverse (-1x) of the daily performance of the Markit iBoxx $ Liquid High Yield Index, by investing in derivatives. The Markit iBoxx $ Liquid High Yield Index is a modified market-value weighted index designed to provide a balanced representation of U.S. dollar-denominated high yield corporate bonds for sale within the United States by means of including the most liquid high yield corporate bonds available as determined by the index provider.
ProShares UltraShort 7-10 Year Treasury ETF (NYSEARCA:PST) – This ETF is designed to obtain investment results which correspond to twice the inverse (-2x) of the daily performance of the the Barclays U.S. 7-10 Year Treasury Bond Index. PST invests in derivatives which ProShares Advisors believes, in combination, should have similar daily return characteristics as two times the inverse (-2x) of the daily return of the index.
Bottom line: The Federal Reserve now finds itself between the proverbial rock and the hard place as financial markets have become dependent upon easy money and quantitative easing. It’s widely recognized that quantitative easing cannot last forever. Either the Fed will end it or the market will force its end via higher inflation and rising interest rates. There’s no easy way out for the bond market, but no matter what happens, it seems that interest rates might have reached a long term bottom and are likely to rise over the coming years. This will be difficult and turbulent for financial markets, however, as always, there will be opportunities for investors who know how to adapt to and exploit changing market conditions.
Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.