I recently published a mostly positive commentary on the stock market suggesting the balance of 2014 would be good for stocks as long as interest rates remained low. Outside of economic growth accelerating over the next couple of months, I feel rates are not likely to move higher in 2014. In terms of the ability for the economy to accelerate, I acknowledge that it could happen, but I expect the current slow pace of growth to continue.
When referring to interest rates, I was referencing the short-term lending rate controlled by The Fed called the Discount Rate. When The Fed becomes concerned about the economy overheating (inflation) they raise the discount rate, which usually moves rates up long the maturity term. There has been some talk of rate hikes by The Fed in 2015, but the bond market remains unconvinced. The Fed can also influence rates with QE, and the current program is on track to conclude later this year. What we have seen in 2014 is a bond market ready to drive up the prices of bonds without The Fed's participation.
On Wednesday, the day after the stock market followed through on its current rally attempt, bond prices shot higher. The Pimco Zero 20+ Coupon Bond Fund (NYSEARCA:ZROZ) jumped up 2.54% and The Vanguard Extended Duration Bond Fund (NYSEARCA:EDV) rose 1.85%. The iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) hit a new all-time high and the iShares Core Long-Term US Bond Fund (NYSEARCA:ILTB) is up 12.1% YTD! Bonds have been one of the best performing asset classes so far in 2014, which may be telling us not all is well with the U.S. economy.
With stocks wavering most of the year, it's not surprising bonds have rallied. But these numbers appear too strong for an economy about to shift into a higher gear, especially after stocks are starting to show some strength.
Tuesday, the stock market followed through on the rally it has been trying to get started since stocks sold off in March and April. If stocks are about to start another leg up, why are investors continuing to chase bonds when interest rates are already puny? Outside of a known long-term cash outflow commitment (think insurance contracts or pension commitments that are not adjusted for inflation), what type of investor would be willing to accept a long-term bond yield around 3.25% with duration risk in the high teens? The answer -- an investor that thinks deflation is a bigger threat than inflation.
On the surface, it may be hard to acknowledge the threat of deflation during a time where the S&P 500 has rallied 180% from 2009 lows (40% higher than 2007 highs), but that may be exactly what the bond market is signaling.
Wednesday's bond buying was attributed to money leaving Europe because of rate adjustments down by the ECB to ward off, you guessed it, deflation. The bond market does not believe the improvement in economic numbers, after the winter weather setback, will be maintained. As a matter of fact, it may be telling us the U.S. economy is more likely to contract during the balance of year. Only time will tell if the U.S. economy can escape the black hole of debt expansion. In the meantime, it looks like I may need to change my outlook for stocks in 2014, because if deflation materializes, it will not be kind to the stock market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.