A Seismic Shift Out of Bonds

by Bryan Perry | August 20, 2012 8:56 am

The yield on the benchmark 10-year Treasury Note has surged from 1.40% to 1.80% since Aug. 1 and is now at its highest level in three months. Recent data pointing toward an improving U.S. economy  — including last week’s industrial production, retail sales figures and today’s housing starts —  all surprised to the upside.

The Fed’s stimulus programs are ultimately inflationary, and they still may add liquidity to the system as a form of insurance before stepping aside as the election approaches, and CPI data out Friday was very tame. The next big deal for how the Fed is thinking is at the Aug. 31 Jackson Hole Symposium, where Fed Chair Ben Bernanke will speak.

The Fed’s goal in quantitative easing is in part to drive investors to riskier assets, i.e., stocks. Bottom line: Expect more verbal intervention versus the real thing. Old-fashioned jawboning was enough for a huge $9 billion sale of 10-year T-Notes hitting the bid in overnight trading two days ago by a large Asian (maybe Chinese?) customer. Pimco co-chief Bill Gross told The Wall Street Journal that “30- and 10-year Treasurys should be sold in favor of safer five-to-seven-year maturities.”

Assuming the seeds of future inflation have been planted, income investors should be rotating into inflation-sensitive assets that not only counter the higher cost of living, but also offset the devaluation of sovereign currencies such as the dollar and euro due to extreme growth in government debt issuance. About 60% of all U.S. debt will mature in the next three years.

It’s a priority to be long high-yield hard assets that move up in tandem with — if not outpace — the rate of inflation. Consider the triple threat of inflation now at work. The drought has pushed grain prices to all-time highs and will affect future food prices. There’s the coming issuance of trillions in dollar- and euro-based debt to service ballooning government budgets where fiscal discipline remains elusive at best. And consider what the price of oil will skyrocket to if Israel bombs Iran’s nuclear facilities.

In this developing global backdrop, investors should highly consider being long floating-rate corporate debt, domestic onshore oil and gas exploration and production income trusts, corn fertilizer master limited partnerships (MLPs) and some precious metals. Period. No exposure to the Middle East or to deep-water drilling disasters in the Gulf of Mexico. Instead, full exposure to higher interest rates, future conversion to natural gas, and record plantings in corn and other grains.

The S&P 500 has quietly managed a move up to the next resistance level at 1,400 where I’d expect a period of consolidation to digest the gains. The one-year chart below of the S&P shows that the current technical level is a critical one. The market failed twice at this level in April, and chartists are sending out cautionary alerts all over Wall Street now.

Granted, we could see a pullback for the S&P to 1,360-to-1,380 on any set of negative headlines, but the uptrend of late has the look of money rotating out of bonds and into equities — and that’s a force to be respected, even by the perma-bears. A clean break above 1,420 would take the benchmark index up to 1,450, and you can count on one hand the number of market forecasters predicting that move.

Sector rotation is the name of the game. If this week is any indication, investors who are camped out in long-dated Treasurys will get crushed. It’s time to shorten up maturities, get long some floating-rate debt and own some hard assets as the central banks keep minting debt to inspire more risk-on investing in equities and real estate.

We can’t know all the reasons why this shift is occurring now when the larger macro data has been softening up in the past two months, but the market senses the bad news that’s fit to print is priced into the bond market, and money is moving out.

Given the uncertainty about the year-end looming fiscal cliff dilemma fast approaching, I’m of the opinion that we’ll see a sideways market until some of the global obstacles — such as the rising tension of an Israeli-Iranian confrontation, the presidential election and its impact on future tax policy, and the rebounding price of gasoline as headwinds against any further meaningful upside for the major averages — are resolved. It has been a good run, and we should all be grateful.

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