In fact, higher bond yields can serve as a brake on the economy in their own right if they contribute to a slowdown in the housing market. Clearly, the potential for the largest surprise on the economic front is now slower-than-expected growth — which of course would be a positive for bonds.
Other potential supportive factors include surprises stemming from the European elections, a further slowdown in China’s economy, uncertainty created by this autumn’s U.S. budget battles or protracted stock market weakness.
While the odds are against all of these individually, the possible “surprise” again works in favor of bonds in all cases.
#3: The Short End Is Pinned
The Fed, in keeping the fed funds rate pegged at zero, is going to depress the short end of the yield curve indefinitely. This has caused the yield curve to steepen considerably, putting it at its steepest incline in two years — a shape that isn’t supported by an environment of low growth and tame inflation. While a further steepening is certainly possible, the current shape of the yield curve should soon begin to act as a drag on longer-term rates.
#4: The Rate of Yields’ Increase Has Reached Historic Levels
Barry Ritholtz at the Big Picture posted this chart on Monday, which shows that the rate of change in Treasury yields are (almost literally) off the charts in terms of the pace of their increase relative to history.
#5: Fund Flows Have Reached Extreme Territory
The exodus from bond funds, as noted above, is a sign of extreme distress among individual investors — an important contrary indicator. Bond ETFs make up half of the top 10 funds in terms of net redemptions since June 1, led by the nearly $4 billion in outflows from the iShares Investment Grade Corporate Bond ETF (LQD). This presents contrarian-minded investors with a chance to go against the herd.
How to Play It
Add it up, and the most recent downleg offers the chance for longer-term investors to consider adding to positions, and for traders to prepare for a shot from the long side.
Those looking to generate quick returns usually look first to iShares 20+ Year Treasury Bond ETF (TLT), but another fund to consider is PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ). The fund has consistently demonstrated stock-like volatility due to its ultra-long duration, and it has done so without the tracking problems associated with leveraged ETFs – traders’ other top choice for bond-market beta.
The Bottom Line
Stepping up and buying bonds in the teeth of tapering fears is a difficult decision to make, but the best investment ideas usually are. Consider this a prime opportunity to turn bond investors’ fear to your advantage.
As of this writing, Daniel Putnam was long ZROZ.