john@johnducas.com

____________________

Bonds: The Great Escape?

I am writing this article after the pop we saw in US treasury yields on Friday. This was followed by a better than expected jobs report. You probably already know this but bond prices fell because the stock market rised.

 

During the recovery, people have been buying both stocks and bonds. You can see this by the chart just under.

 

Screen Shot 2013-05-04 at 2.05.07 PM

http://finance.yahoo.com/echarts?s=%5EDJI#symbol=%5Edji;range=20061211,20130430;compare=%5Etnx;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

 

The chart shows the correlation between the DJA and the CBOE 10-year US treasury yield. As you can see, as stock prices have been increasing, so have bond prices

 

The main fear going around is that at one point, treasury yields will be so low, that investors will flock somewhere else, more specifically the stock market.

 

I’ll give to an example to understand the severity of the situation. The average rate of inflation in the US is about 2.3% a year. The 20-year t-bond pays out an interest rate about 2.39%. Since you collect the interest twice a year, this would mean that at the end of each year, you would receive a total of 2.48%. This isn’t much compared to the 14% the SPY gained over a year. Now you can see how an investor will look at this difference and move his money to stocks. Friday was a prime example of this, investors moved some money into stocks and out of bonds.

 

Inflation is something else that will cause panic amongst bond investors. Ever since the recession, inflation has been very low. But with all the money the FED is printing, it has started to increase. This can be seen from the PPI (Producer Price Index), which has increased over the past year. This will certainly be shown in the CPI (Consumer Price Index) numbers coming over the next few months. This will cause inflation which will translate into the panicking of bond buyers.

 

Therefore what could cause a movement out of bonds and into stocks? A stronger economy.

There is no point of getting one’s hopes to high because the main factor of lower bond prices isn’t totally in place, and that is the economy. It’s going to take some time for the economy to start growing at a rapid enough pace for the movement to happen. The FED even said that the economy would take some time to take off. The Federal Reserve also declared that interest rates would be kept to a low for a long time going into 2014. This is very important, as the FED’s bond buying program has managed to keep the interest rates so low for such a long time. Many analysts believe that low interest rates could extend even longer than what the FED said. Pimco’s Bill Gross who many consider to be the ‘Bond King’ also stated that ‘growth and unemployment will not reach levels to cause the Fed to raise rates until at least 2015’.

 

The Fed has been injecting a lot of money into the economy; the problem is that people are not spending that money. Instead, they either saving it, or buying other assets like real estate or financial. This is another reason why bond prices remain low. If this were the contrary, it would have been shown in the CPI (Consumer Price Index).

 

The bull market in bonds has been going on for more than 30 years, the question is, when will it stop?

 

Screen Shot 2013-05-04 at 3.05.21 PM

 

http://finance.yahoo.com/echarts?s=%5ETNX+Interactive#symbol=%5Etnx;range=19810713,20130401;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

 

In an interview with the financial times, Mr. Gross reassured bond investors by saying “I don’t see a bond bear market on the horizon until this magical potion of cheque writing and policy rate stabilization creates some type of nominal growth.”

 

Sure, all these things make you think ‘heck, bonds are the perfect place’, but I wouldn’t be so sure. Until Friday, I was of that opinion too. But having seen how fast euphoria can take over, I am way less confident. It showed how fast things can turn around, especially after good news. I think that more good news is yet to come, and it is for that specific reason that I’m sitting this one out. A reversal could happen at any time, either towards the bearish side, or towards the bullish side. Good jobs reports or worries coming from Europe could send the price much higher, but the opposite scenario could also happen.

Also, the current yield isn’t nearly enough to make me board ship. Right now, I’d rather be in equities.