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Summary

  • A constant refrain over each of the last six years has been the imminent bursting of the bond market bubble.
  • But the bond market continues to rallying smartly in 2014.
  • The bull market in bonds is now in its 32nd year and remains very much intact.
  • The latest rally in bonds has brought with it a new and unusual cast of asset class characters this time around.

A constant refrain over each of the last six years has been the imminent bursting of the bond market bubble. But with each passing year, the bond market continues to defy the skeptics. Despite all of the talk about the Fed ending its quantitative easing program and the threat of rising interest rates in the coming year, the bond market has not only been holding its own but also has been rallying smartly in 2014. The bull market in bonds is now in its 32nd year and remains very much intact. And the latest rally in bonds has brought with it a new and unusual cast of asset class characters this time around.

A widespread bearish view overhung the bond market entering 2014. After a dismal showing over the last eight months of 2013 that saw 10-year U.S. Treasury yields nearly double from a low of 1.61% in May to 3.04% at the end of December, the conventional thinking was that the "bubble" in the bond market had finally burst. The fact that the Fed was set to end its third quantitative easing (QE) program coupled with expectations for the U.S. economy to increasingly accelerate in 2014 only added to the belief that bond yields had nowhere to go but up. But from the moment the calendar flipped to 2014, bonds (NYSEARCA:AGG) have been in an uninterrupted rally mode that only seems to be picking up steam.

Why Bonds? Why Now?

So what exactly happened that caught so many investors flat footed on bonds?

First, the persistently uncertain global economic and geopolitical environment since the outbreak of the financial crisis seems to have accelerated the pace of the bond rally in recent years. To highlight this point, it is worthwhile to go all the way back to the beginning of the current bond bull market back in 1982. For the first 25 years of the bond market rally, 10-year U.S. Treasury yields were traveling in a well-established downward sloping channel. But following the start of the financial crisis in 2007, a new and even more steeply downward sloping yield channel has emerged. This new channel has been well tested over the last seven years now and shows no sign of relenting anytime soon following the latest test of support at around 3% at the end of 2013.

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Second, in what is arguably the most puzzling and persistent misconception in the investment world, it is still a widely held belief despite so many years and so much stark evidence to the contrary that it is bad for bonds when the Fed stops QE. In fact, bonds have performed poorly during periods when the Fed is actively engaged in asset purchases and have rallied strongly once these asset classes are drawn to a close. How can this be possible? Well the Fed is not the only market participant that is buying bonds at any given point in time. And historical the loss of demand from the Fed is more than offset by investors seeking refuge from the stock market. Whether this happens again the next time around remains to be seen, but the bond market is following a similar pattern to what was seen toward the end of QE2 from February to June 2011 when they rallied in advance of the program coming to an end.

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Third, the global economy remains sluggish and is not getting meaningfully better any time soon. For each of the last five years, the refrain going into the year has been that a strong and sustained economic recovery would finally arrive. It didn't show up in 2010. It didn't arrive in 2011. It never came around in 2012. It did not come to pass in 2013. And it's not happening again this year in 2014. Sure, the economy is OK in the U.S., but growth has been uneven at best and looks fairly lousy in places like Europe. And uncertainty about the achievability of an even more modest outlook is now in doubt given the geopolitical uncertainty that is overhanging many parts of the globe. Such are the conditions that are favorable for high quality bonds including U.S. Treasuries.

Lastly, the United States continues to represent the best destination for safety seeking investors that would also like some additional yield. The following is a chart that compares the yield on the 10-year Treasury versus the yields from comparable 10-year government bonds across many of the largest economies around the globe. The 10-year U.S. Treasury yield in the U.S. is currently 2.34%, which compares most favorably to that of Japan, Germany and Switzerland, all of which are below 1%. It also stacks up well against France and the Netherlands with U.S. Treasuries offering a full percentage point or more. And in what is among the most notable comparisons, Spanish 10-year government bond yields are only trading at yields that are 5 basis points higher at 2.39%. Italy is not far behind at 2.58%.

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How Much Longer Can The Bond Rally Run?

The bond rally is showing no signs of letting up despite all of the expectations to the contrary.

So where do we stand today. Much like stocks as measured by the S&P 500 Index (NYSEARCA:SPY), the 10-Year Treasury enjoys a strong netting of technical support at current level. Yields successfully tested support at 3.00% at the end of last year, and they recently broke below a key resistance level at 2.40%. If yields can hold this recent breakout, the next stop for the 10-year would be a yield in the 2.05% range if not lower.

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This 2.05% level is particularly important from a technical perspective, as it also represents the mid line of the downward sloping channel that has been in place since late 2007. A break back into the high 1% range on the 10-Year Treasury yield would be a particularly bullish signal for bond investors that further upside may be ahead in bonds (NYSEARCA:IEF) in the coming months.

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It should be noted that the 30-Year Treasury has also been along for the ride in the recent bond market rally. After popping above critical support at the 3.50% yield level toward the middle of last year, the long bond (NYSEARCA:TLT) has since reclaimed this support level and continues to push its way lower. At this rate, it would not be surprising to see 30-Year Treasury yields fall back into the high 2% range before long.

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All of this suggests that either the economy is once again not going to accelerate the way that stock investors have mistakenly believed it would for the last five years and counting. Or the Fed is not going to raise interest rates as quickly as so many currently expect. Or both.

The Stock Sectors Benefiting Most From Falling Treasury Yields

The good news for stock investors is that several more interest rate sectors appear to be directly benefiting from the decline in yields since the start of the year. What is perhaps most notable is that many of these sectors including the three that are mentioned below are not typically correlated very much at all with long-term U.S. Treasuries but have been showing a very strong relationship more recently.

For example, utilities (NYSEARCA:XLU) and bonds as measured by the TLT have moved at least until very recently with a very high correlation to one another.

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REITs (NYSEARCA:VNQ) have also moved very closely with U.S. Treasuries since late last year.

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And preferred stocks (NYSEARCA:PFF) have tracked U.S. Treasuries over much of the last year, only showing signs of deviating for the first time over the past week or two.

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In short, the acceleration higher in Treasury yields thus far in 2014 has not come at the expense of stock investors (at least not to this point). Instead, it has take place along side stock investors, with a particular benefit to those sectors that are more interest rate sensitive that have benefited most.

Bottom Line

Despite all of the persistent fears and expectations that bond interest rates can go nowhere but higher in the year ahead, the bond market is telling a different story. U.S. Treasuries have been rallying well so far in 2014, and it seems that those that are driving this push lower in yields are not deeply concerned about the possibility of higher rates. Instead, it seems that the consensus view from the bond market is that the economy is set to remain sluggish and while QE3 may soon be coming to an end, which is historically bullish for bonds, the Fed will be reluctant to take the next step and actually raise rates any time soon. And for those stock investors that are allocated to sectors that are particularly sensitive to higher interest rates, this is not only a welcome development but may present some attractive buying opportunities along the way.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Source: A Market That Defies All Expectations

Additional disclosure: I am long selected individual utilities and REITs.