Stocks tumbled early Tuesday and bonds soared, giving ample evidence that news of the death of the bull market in Treasurys — not to mention fears of higher interest rates — was greatly exaggerated.
True, the risk-on trade so far in 2012 has been great for equities and bad for debt. Investors have embraced better economic news at home, an orderly Greek debt default and a more mild-than-expected recession in Europe to send stock prices off to their best start in more than a decade.
Meanwhile, Treasurys are lagging badly for the first time since financial crisis hit. The Barclays Capital 7-10-year Treasury index is off 2.9% year-to-date, while the 10-20-year index has logged a total return of -4.9%. The S&P 500, however, is still up more than 11% on a price basis, even after Tuesday weakness.
Still, Treasury prices have been falling — and yields rising — rather sharply of late, giving some investors pause that the bond bubble could be deflating and rising interest rates, especially for mortgages, could choke off the recovery. (Recall that bond prices and yields move in opposite directions.)
But those fears are overblown, economists and analysts say. After all, the yield on the benchmark 10-year Treasury note broke above 2% on March 8 and has since leaped to 2.35% — but it’s still historically low. Heck, it jumped as high as 3.62% about a year ago, but that spike didn’t stick.
“Natural Ebb and Flow”
Just as stocks never move in a straight line, neither do Treasurys, notes David Rosenberg, chief economist and strategist at asset manager Gluskin Sheff.
“What we are seeing occur is the natural ebb and flow in the market — yields do not move up and down in a straight line, especially in an era where underlying deflationary pressures bump continuously against periodic reflationary government and central bank policies,” Rosenberg writes in a new note to clients.
Lest we forget, Rosenberg says, Treasurys rallied sharply in 2010 and 2011 (they delivered a total return of 17% last year), and in both periods the market “endured no fewer than four powerful interim selloffs.”
Going all the way back to 2008 — a year in which the 10-year note yield sank from 4.04% to 2.25% — “there were exactly EIGHT periods of yield hiccups of at least 30 basis points (the average being 40 bps),” Rosenberg says. (A basis point equals 0.01%.)
Why the Sell-Off?
A bunch of reasons account for the recent sell-off in Treasurys, notes economist Ed Yardeni, president of Yardeni Research. Better-than-expected February reports for U.S. employment and retail sales boosted the case for the country’s recovery gaining steam, which means investors need to think about potentially higher inflation. (Not that inflation is being predicted by other key markets: Both commodities and gold, which are highly attuned to inflation, are trending down.)
But more important was the Federal Reserve’s latest comment on the economy. Bernanke and the Fed’s rate-setting committee upgraded their view of economic growth to “moderate” from “modest.” The bond market interpreted that to mean the central bank won’t be launching a third round of quantitative (QE3) easing anytime soon. Meanwhile, the Fed’s current fiscal stimulus plan — Operation Twist — is set to expire in June. Concern that the Fed will stop buying long-term Treasurys naturally results in lower prices and higher yields.
But Yardeni and others say chances are very good that the rate-setting committee will extend Operation Twist — or come up with another plan, like so-called sterilized bond purchases, especially if bond yields start moving higher.
“The Fed’s excuse for doing so is likely to be that the housing recovery remains fragile, so it is important to keep mortgage rates low,” Yardeni writes in a note to clients.
More Growth Needed
Jan Hatzius, chief U.S. economist at Goldman Sachs (NYSE:GS), is telling clients QE3 is certainly still on the table. For one thing, the recent improvement in the economy may not last. “With real GDP growth tracking just 2% in the first quarter and signs that at least some of the recent strength is probably due to the unusual warm weather and perhaps some seasonal adjustment distortions, question marks still surround the true pace of activity growth,” the economist writes.
Additionally, unemployment remains stubbornly high and — perhaps most important — failure to enact more fiscal stimulus is essentially equivalent to raising interest rates, which is the last thing the Fed wants. “A decision not to ratify expectations of QE3 could therefore result in a tightening of financial conditions,” Hatzius says.
Yes, at some point long-term rates will rise. That will be a shock to any bondholders who don’t see it coming. But higher rates will also be a balm to America’s long-suffering savers and, if all goes according to plan, they’ll indicate that the economy and joblessness are truly on the mend. Regrettably, we’re not there yet, the recent spike in Treasury yields notwithstanding.