Is The Bond Market Worried About Equities?

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 |  Includes: DTYS, IEF, IEI, PST, TBX, TYO, UST
by: Invesco US

Summary

The bond rally was likely driven by noneconomic factors.

In similar past rallies, economic growth remained strong.

I believe equities have further upside potential this year.

By Rick Golod

In May, the yield on the 10-year Treasury note unexpectedly fell 22 basis points.1 Bond markets tend to rally (prices rise as yields fall) when investors believe difficulties may lie ahead, such as an increase in equity volatility or an impending recession.

However, the recent rally seems at odds with current economic conditions. As outlined in my June commentary, "Don't Fight the Central Banks," the economy is showing signs of reacceleration.

What is the bond market telling us?

I tend to agree with Invesco Fixed Income's Chief Strategist, Rob Waldner, who believes these six factors contributed to the recent decline in the 10-year Treasury yield:

  1. Short covering. Speculative investors who held short positions in the 10-year Treasury early in the year have been forced to cover their positions (that is, buy back the borrowed securities) as prices rose.
  2. Increased demand from China. In attempting to weaken its currency, China has been a more active buyer of U.S. Treasuries lately.
  3. Institutional portfolio rebalancing. After last year's strong equity returns, pension funds have been rebalancing their stock and bond allocations, moving assets from equities into bonds.
  4. Better relative value. Lower European bond yields have helped bring U.S. yields down. Currently, the yield on the Spanish 10-year sovereign bond is lower than the 10-year Treasury's, despite Spain's 26% unemployment rate and 0.50% gross domestic product (GDP) growth rate.2 From a risk-reward standpoint, I believe U.S. Treasuries offer a better value.
  5. Tighter supply. The Federal Reserve (Fed) owns the majority of government bonds, reducing availability. Any rise in demand could take prices higher and yields lower.
  6. Fed policy. Fed Chair Janet Yellen's guidance to continue the Fed's zero interest rate policy for another couple years has calmed fixed income markets.

Additionally, another reason I believe Treasury yields declined could be that banks were forced to buy bonds to try to meet their capital-to-risk-weighted-assets ratios.

Should you worry?

Whatever the reasons, this is not the first time bond yields have declined for noneconomic reasons. In the seven occurrences in the past 35 years (1984, 1985, 1986, 1993, 1997, 1998, 2002 and now 2014), GDP growth in the year that followed averaged nearly 4% and was never below 2.8%.3

In addition, I believe fixed income prices may be near a high for the year. The ratio between the Dow Jones transportation and utility sectors is highly correlated to the 10-year Treasury yield. The transportation sector just hit an all-time high, while the utility sector declined nearly 5% in the first three weeks of May, which increases the ratio and the probability that bond prices could fall from here.4

For these reasons and the upside potential I see in equities for the remainder of the year, the risk-reward profile for equities remains attractive, in my opinion.

1 Source: Bloomberg LP, May 31, 2014

2 Source: Bloomberg LP, June 11, 2014. GDP growth rate and unemployment data as of March 31, 2014.

3 Source: Gluskin Sheff, June 4, 2014

4 Source: Bloomberg LP. The Dow Jones Transportation Average was measured as of June 9, 2014, and the Dow Jones Utility Average was measured from May 1, 2014, to May 19, 2014.

Important Information

A basis point is a unit that is equal to one one-hundredth of a percent.

The Dow Jones Transportation Average is a price-weighted index of 20 U.S. transportation stocks.

The Dow Jones Utility Average is a price-weighted index of 14 U.S. utility stocks.

Correlation measures the degree to which two variables move in tandem with one another.

Capital-to-risk-weighted-assets ratio, also known as capital adequacy ratio, is a measure of a bank's capital relative to its risk exposure.

About risk

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.

Issuers of sovereign debt or the governmental authorities that control repayment may be unable or unwilling to repay principal or interest when due, and the fund may have limited recourse in the event of default. Without debt holder approval, some governmental debtors may be able to reschedule or restructure their debt payments or declare moratoria on payments.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE
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The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

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