The Bond Bust Has Begun

Includes: LQD, TBT, TLH, TLT
by: Abigail Doolittle

There’s no question that the last thirty years have been very good to the bond market.

In fact, the chart above may even paint the picture of what could be called the Great Bond Bull Market with price moving inverse to yield.

While I have been writing for months about thinking the “bond bash” is coming to an end, I think we may have seen the true beginning of that end in the last week with the 10-Year Treasury yield spiking about 55 bps higher since last Monday.

And what might have been the impetus to bring about this potential end to the bull market in bonds?

Interestingly, the most obvious possibility is also all but impossible, and perhaps the reason why many seem to be surprised by the 107 bps or more than 1.0% move up in the 10-Year in about two months.

This “impossible” possibility is the Federal Reserve raising rates. While Fed Chairman Ben Bernanke said he could raise rates in minutes if need be in a recent interview, such a raise would be in response to any possible inflation down the road that might stem from QE2 or a need to slow the economy.

Rather, I think it makes sense to take a look at the following factors.

  • Stronger prospects for the economy,
  • Budget deficit or fiscal worries,
  • Inflation expectations/risk, and,
  • Loss of confidence in the Fed, its monetary policy and QE2.

Last week, we saw the perfect storm of these four factors coming to play and there have been two sources to bring this confluence about.

First, the tax compromise between President Obama and congressional Republicans has been viewed by many as a “second stimulus” for the U.S. economy with many economists viewing the extension of the Bush-era tax cuts and payroll tax cut as a reason to raise their 2011 GDP forecasts. In turn, such economic growth could have the potential to bring about a rise in prices or inflation. Simultaneous, however, this tax deal has caused concerns around its effect on the U.S. budget deficit with some economists pointing to the possibility that the tax breaks could bring the deficit close to 10% of GDP next year.

So with Obama’s deal-making, three of those four factors occurred that could bring about an overall decline in the bond market.

The first – economic growth – is likely to drive investors toward equities and out of bonds since stocks should perform better than bonds during a time of economic expansion.

The second – unsustainable fiscal policy – is likely to drive investors toward precious metals and other physical and transferrable stores of intrinsic value and out of bonds that will suffer from such policy.

The third – inflation – is related to that unsustainable fiscal policy and will be the most powerful force of these three, in my view, to drive investors out of bonds since rising rates will cause the value of bonds to decline while curbing the value of interest received.

The second source to bring about two of the aforementioned factors, in my view, was Fed Chairman Ben Bernanke’s recent 60 Minutes interview. For in that interview, not only did Mr. Bernanke speak in a somewhat unpolished and even abrasive manner, but he hinted at the idea that the Fed’s current round of quantitative easing to help stimulate the economy could be altered – as in expanded – as needed.

In the past, this communication may have been received by bond investors with cheer since the possibility would exist for a steady stream of the government’s support for the Treasury market, but investors seem to have gotten smart to Mr. Bernanke’s subtle form of bluffing by committing to nothing specific about such bond purchases while intimating that the Fed could be a constant inflationary force on the markets for some time to come.

Mr. Bernanke may be “100% confident” that he and his team can tame inflation quickly by raising rates but that view does not seem to be shared by fixed income investors and perhaps the early bond vigilantes.

While some of the sell-off in Treasurys may be linked to improved prospects for the economy, I think more of it has to do with investors signaling to the Fed that as a collective the fixed income markets will not tolerate the Fed Chairman’s continued puppeteering especially when his proposed actions could bring about inflation that is unlikely to be be tamed overnight.

Put otherwise, I think the current decline in Treasurys signals some loss of confidence in Ben Bernanke’s Federal Reserve.

Putting aside any early action out of the bond vigilantes, however, and returning to the idea that increased economic expectations might support a bust in the bond markets, it may be a slow unwind but it’s very much underway as this chart of an investment grade bond ETF shows us.

In addition, as I discussed two weeks ago, the S&P 500 earnings yield of about 6.5% suggests that bonds are expensive with the 10-year yield at 3.49%.

The Fed Model points to the idea that equilibrium between the two markets is found when the S&P earnings yield is close to that of the 10-year yield and, if correct, and it should be noted that it may not be but this non-Fed endorsed methodology does seem to point to meaningful relationships over longer periods of time, and seems to point to the idea that yields are likely to increase as will the S&P 500.

And so it is this inflation expectation/risk and perhaps an increasingly less tolerant stance toward the Fed’s until now artful maneuvering of markets to create movement that is the most likely driver of the end of the Great Bond Bull Market, in my view.

After all, the 10-year’s rise in yield has been telegraphing this message to us for two months now in the chart below of the roundtrip QE2 trade.

It may have been more difficult to believe its message a few weeks ago but now with the fixed income markets mimicking its message seemingly across the board, investors may want to consider taking a seat by reducing exposure to bonds before this market’s music ends entirely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.