Bond Market Update: Canaries In The Coal Mine

by: John M. Yenkes

The combined effects of record money supply, removal of quantitative easing, China's trade deficit, and a quickening U.S. economic recovery will end the multi-year bull market in bonds, and the sell off could be swift.

Taking a look at M2 money supply, recent data shows yet another increase, and that we are approaching a record $10 trillion in total U.S. currency in circulation. As past periods of high inflation have taught us, once price escalations have begun it tends to accelerate quickly, making it difficult for the Fed to put the monetary genie back in the bottle using ordinary tightening measures. While nagging unemployment, falling home values, and excess capacity has so far dampened core inflation, recent economic, housing, and labor market reports all suggest the slow grinding recovery may start to quicken in the coming months. Recent FOMC comments from the Fed show a round of QE3 is increasingly unlikely, and that the economy will continue improving without fresh buying from the Fed.

The bond market has taken notice, with the long end of the market selling off sharply in recent days. However, this is likely just the beginning. Adding fuel to the fire will be a continued reduction in purchases from both Asian and U.S. investors. Recent data show a widening trade deficit and worsening problems in the Chinese housing market, which will reduce Asian appetite for U.S. debt. As the economy continues to heal, more retail and institutional U.S. investors will seek out higher yielding fixed income or equities. While the Fed will likely keep the short term fed funds rate low, all of this will add up to a steepening yield curve as long dated bond yields rise considerably by years end.

So, what does this mean for your portfolio? I suggest a portfolio shift into equities and away from bonds. Those with more risk tolerance should look at quality financial equities with higher betas such as JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC) and The Hartford (NYSE:HIG). If you are currently long on bonds, in addition to closing positions, you might consider hedging with TBT; this ETF produces 2x the inverse of long dated Treasuries and allows you to take some bond risk off the table without actually liquidating your bonds.

If you are an income investor looking for yield, you might want to consider a select few REITs as well. Many mortgage REITs such as Two Harbors (NYSE:TWO) and Invesco (NYSE:IVR) are paying yields in the mid-to-low teens, and have effectively hedged their short term interest rate risk. In addition, these REITs will actually benefit from a steepening yield curve as their income and dividends are affected by interest rate spreads.

Other specialty REITs such as Heath Care, Inc (NYSE:HCN) and Digital Realty Trust (NYSE:DLR) offer compelling mid single digit yields with a strong track record of growth. Note in the case of mREITs not all interest rate risk can be eliminated over the long term, and as rates continue to rise after years end, mREIT positions should be closed or reduced.

Disclosure: I am long TBT, JPM, TWO, DLR, HCN, HIG.