The Great Rotation Out of Bonds

by Bryan Perry | November 23, 2013 9:00 am

The market is welcoming the induction of Janet Yellen as the next Federal Reserve Chair with open arms — and buy orders for all manner of ‘risk on’ assets — after she reassured the investment community that fiscal stimulus in the form of quantitative easing will be perpetuated during the first leg of her time in that office, which will begin in January. She essentially sailed through her Senate banking committee confirmation hearing, and the market rewarded the event, with the S&P 500 hitting 1,800 on Monday.

Bond yields have come up from unprecedented lows. The weak economy, tiny inflation and exceptional Fed policies took bonds to historically low levels that bottomed in late June and have since begun to normalize. At some point, the economy will show more consistent growth, yields will rise to more natural levels and existing bonds with their lower yields will fall in value, a lot of value.

I, for one, believe that the process has finally begun. The yield of the 10-year Treasury note has risen to 2.7% from about 1.6% since mid-summer. Treasury-bond funds have fallen in value, some leveraged funds by as much as 25%, leading some money managers to accelerate the selling of funds holding Treasuries and other high-grade bonds. The catalyst for this is the Fed’s more vocal plan to start trimming its $85 billion in monthly bond-buying stimulus — the timing of which is the bigger story. No one knows how fast the Fed will proceed, how fast yields will rise and what level of pain it will extract for bond prices.

At present, U.S. taxable-bond funds hold $3.8 trillion, up from $720 billion in 2000, meaning that Americans are far more exposed to bonds than they have ever been. I’ve been stating for some time now that I want to position myself well in front of another downward shift in bond prices similar to that experienced in late June. That was a rude awakening that the Fed wasn’t walking its talk, which put the long end of the yield curve on red alert.

The great mystery for both the largest and the smallest fixed-income investors alike is that this Fed stimulus program has never before existed and never before been withdrawn, so there is no historical track record. This leaves all of us to speculate on what the unwinding side of QE will look and, more importantly, feel like in dollar terms. QE is tied to job creation improving to sub-7% unemployment that we know is a clear directive of the Fed. Mortgage markets, auto sales and other forms of discretionary spending have improved, leading many closely followed investment analysts to conclude that tapering will come sooner than later, with late Q1 2014 as a target, despite what Janet Yellen is pontificating.

The consensus among most of the biggest bond-fund managers is that the 10-year Treasury yield could move up to about 3.2% or 3.25% in the first part of next year. Because inflation and economic growth are low, I don’t expect the 10-year yield to exceed 3.5% until maybe 2015. Still, a move to 3.25% from the current 2.7% level is significant for fixed-income markets and will prompt further rapid rotation into other forms of hybrid income.

Source URL: https://investorplace.com/2013/11/bonds-fed-janet-yellen/