Bonds Look Steady…At Least for Now

Economic indicators point away from panic

By Richard Band

Grizzlies on the loose!  Bond bears are snarling and flexing their claws, especially after Wednesday’s release of the October Federal Reserve policy minutes.  “Fed’s gonna taper,” the bruins growl.  “Interest rates have nowhere to go but up.”

Sounds fairly plausible, until the contrarian inside you wakes up and realizes, “Hey, everybody is repeating what everybody else is saying, with all the same warmed-over arguments.”

What was it that General Patton cautioned us?  “When everybody thinks alike, somebody isn’t thinking.”

Sure enough.

A lot of the bond bashers really aren’t thinking very carefully at all.  For one thing, they haven’t stopped to ask themselves a simple question.  Why has the Federal Reserve kept overnight interest rates at essentially zero for five whole years?

The answer, of course, is that we’ve had an extremely weak economic recovery.  To predict that bond yields will rise significantly, and sustainably, in the months ahead, you’ve got to believe that business activity is about to accelerate sharply.

Is there any solid evidence of that?  Take a peek at the Citigroup Economic Surprise Index, charted here.  (Original graph courtesy of Dr. Ed Yardeni.)  This indicator looks at incoming economic reports and classifies them as meeting, beating or falling short of the analyst consensus.

As you can see, the flow of positive surprises peaked in September and has since fallen to just above the zero line.  In other words, positive surprises are now barely outnumbering negative.  While I can’t rule out some kind of a bounce from here, each economic rally since early 2011 (see black downtrend line)  has been weaker—not stronger—than the last.

That’s hardly a recipe for a bond holocaust in the months ahead.

Technically, too, I’m detecting signs that bond prices are forming an important bottom in here (yields are making a top).  This next chart overlays the price performance of two exchange-traded funds that focus, respectively, on investment-grade corporate bonds (LQD) and long Treasuries (TLT).

Both sectors of the bond market carved out a low in late August and early September. Treasuries are now threatening to undercut their summer lows, but corporates are holding comfortably above those levels.  Municipals (MUB) are following the same pattern as corporates.

This type of divergence frequently occurs near significant turning points for bonds.  Treasuries are usually the odd man out, giving a false signal to investors who don’t bother to check what the rest of the bond market is doing.

Bottom line:  This is a good time to be buying bonds and preferred stocks, at least for a trade (six to 12 months, perhaps longer).  Just make sure you’re ready to sell, too.  We’re not going to hold these things forever—certainly not after interest rates launch into a genuine long-term uptrend.  “Rent” bonds, don’t own them!

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