What the Bond Market Rally Says About Growth – and Stocks

The bond market is flashing a warning sign about the economy

   
What the Bond Market Rally Says About Growth – and Stocks

So much for that bond bear market.

Coming into this year, the one thing just about every expert could agree on is that the Federal Reserve’s decision to taper its quantitative easing policy would cause bond yields to rise (and prices to fall).

There’s still a long way to go in 2014, but thus far this widely-held view has been way off the mark.

After closing 2013 with a yield of 3.03%, the 10-year Treasury yield has plunged all the way to 2.5%. The move in the 30-year also has been impressive, with that Treasury yield falling from 3.96% at year-end 2013 to 3.33% at Thursday’s close.

The result has been strong returns for those who ignored the dire predictions and held on to their bond funds. The iShares 20+ Year Treasury Bond ETF (TLT) has gained 12.9% so far this year, outstripping the 1.9% return of the SPDR S&P 500 ETF (SPY) by a wide margin. Even the relatively staid Vanguard Total Bond Market ETF (BND) has posted a gain of 3.5%, comfortably ahead of SPY.

This wasn’t how the script was supposed to play out.

And this time around, Fed policy isn’t the reason for the rally.

While the Fed is maintaining its bond-buying program, it’s now purchasing $45 billion of bonds each month ($25 billion in Treasuries), down from the peak of $85 billion ($45 billion of which was Treasuries). This equates to a 45% drop in Treasury purchases in just five months. While this decline was widely expected to result in an increase in Treasury yields, the opposite has in fact occurred — indicating just how impressive this bond market rally has been.

The key question now is whether this move is justified by economic fundamentals, or whether other factors are at work.

On one hand, short-covering has played a part in Treasuries’ strength, as bearish investors have been forced to close out positions. Further, the bond market is likely experiencing a degree of mean reversion in the wake of the nearly universal negative sentiment of late 2013.

It’s therefore certainly possible that the bond market has overshot and is due for a pullback in the near term.

But at the same time, the strength in bonds is reflecting slower-than-expected growth. The economy has failed to maintain its fourth-quarter strength, and even though recent numbers have been mixed, there has been plenty of ammunition to support the bearish case on the economy. What’s more, the drop in Treasury yields has been corroborated by a number of other indications of weaker growth, such as small-cap stocks’ underperformance relative to large caps, the downturn in the Baltic Dry Index, and softness in both base-metals prices and housing-related equities.

These cross-cutting factors muddy the waters when it comes to reading the bond market’s message, but the picture might become clearer soon enough.

At 2.5%, the 10-year Treasury yield is sitting right at support and is in jeopardy of trending back down to levels not seen since June 2013 — when QE was in full swing. Whether the 10-year Treasury can break through this level remains to be seen, but it should be noted that the 30-year already took out similar support nearly two months ago.

tnx 300x128 What the Bond Market Rally Says About Growth   and Stocks
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tyx 300x130 What the Bond Market Rally Says About Growth   and Stocks
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At 2.5% or above, the bond-market rally can still be written off to technical factors such as short covering or mean reversion. But under this level, the 10-year will be moving into territory that will start to flash a much stronger warning regarding the economic outlook.

A yield of 2.2%-2.5% with $85 billion in quantitative easing is one thing. Those same yields in an environment of tapering? That’s quite another.

If you’re invested in stocks, you should take notice if yields fall much further from here. Stocks have shown the ability to handle bond market volatility and keep plugging higher, whether through falling yields (2011-12) or rising yields (spring-summer 2013).

However, the 167-point downdraft that accompanied Thursday’s sharp drop in Treasury yields indicates that equity investors might have seen just about enough.

Bottom Line

The recent action in bonds indicates that investors might soon need to ratchet down their growth expectations even further — a shift that will eventually feed through into earnings estimates.

The markets have taken the disappointing data in stride thus far, but a sustained move in the 10-year below 2.5% might signal strengthening headwinds for equities.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2014/05/bond-market-bonds-treasury-yield/.

©2014 InvestorPlace Media, LLC

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