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There have been a number of bearish developments for bonds since the start of the third quarter, writes J.D. Steinhilber, founder of ETF newsletter and investment management firm Agile Investing. They are: a string of better-than-expected economic reports, a substantial upgrade in the second-half growth outlook, a spike in oil prices and in commodities generally, and an extended Fed tightening cycle. Yet the 10-year Treasury yield has risen only grudgingly, from 3.94% at the end of June to its current level of 4.24%.

Given this resilience, it is no wonder that few observers are still projecting a substantial rise in long-term yields and many analysts have turned neutral to bullish on the bond market’s prospects.   

With short-term bond yields providing excellent competition and cash yields getting more attractive with each Fed rate hike, we continue to view the risk/reward proposition on longer-term bonds as poor, especially in light of recent developments in Asia that could begin to erode what has been the most important support for the bond market – namely, the willingness of Asian central banks and Asian private investors (especially the Japanese) to recycle their surpluses and invest their savings in U.S. bonds. 

China’s move away from a dollar peg will diminish over time its appetite for U.S. bonds and allow other Asian governments to reduce their bond purchases as well.  In addition, the recent break-out in the Japanese stock market to a new four year high could be a bearish development for U.S. bond prices. 

There has been a strong positive correlation between the Nikkei and U.S. bond yields going back 15 years.  The correlation in these two markets has been a remarkable 90% since 1990, when the Japanese economy entered its protracted deflationary downturn.  Over this period, U.S. bond yields have been an attractive alternative to Japanese savers,  given that the yields on JGBs (Japanese government bonds) have been under 2% for nearly 10 years and the Japanese stock market was in a bear market from 1990 to 2003. 

A sustained recovery in the Japanese economy and stock market, which appears to be taking hold, would imply that demand for U.S. bonds from Japanese investors will weaken as domestic investment opportunities become more attractive.

There is a circular phenomenon at work in the bond market.  Bond prices have shown a tendency to rally in response to every action that could be perceived as a threat to the economy: Federal Reserve tightening, spiking oil prices, sell-offs in the stock market.  Yet falling long-term interest rates, rather than augur economic weakness, have provided the monetary fuel to power the global economy and asset markets.   The Federal Reserve understands that falling long-term rates are a potent stimulus to the economy and that a flat, or inverted, yield curve is not necessarily a reliable harbinger of recession. 

Our favorite business cycle forecasting firm – the Economic Cycle Research Institute – agrees that the yield curve spread is flawed as a leading economic indicator.  According to ECRI, over the past 50 years, there were three occasions when the yield curve did not invert ahead of a recession (including the 1990-1991 recession) and one time when it inverted and there wasn’t a recession (the 1994-1995 tightening cycle).  “That’s three misses and one false signal.

Source: Bond Market Outlook