What Happened to the Bond Bubble?

“All year the consensus regarding bonds has been that they are in a late stage bubble that is about to pop as long-term interest rates will rise and the price of bonds will sharply plummet. The consensus has been wrong. We saw a sharp spike in rates after Fed Chair Ben Bernanke first mentioned tapering QE3 in June, but the long rate has since come back down and currently stands at 2.51%. It seems the demise of the bond market has been a little premature.

Did the Fed Bail Out the Bond Market?

So what happened to the bond bubble that was supposed to pop? A few things have prevented a catastrophe for investors heavily allocated to bonds. The market had been anticipating the start of tapering of QE3, the Fed’s bond-buying program in which they have been purchasing U.S. Treasuries and mortgage-backed securities. Bernanke first mentioned tapering in mid-June and the 10-year rate jumped from approximately 2.20% to 3.0% in a very short time frame. This was a huge move for bonds, however, the market got ahead of itself as the tapering that seemed like a sure thing never materialized. The Fed kept QE3 unchanged due to what it felt was weaker-than-expected economic data. Since the non-tapering decision, the 10-year Treasury rate has come back down to approximately 2.50%. At this point I believe bonds are fairly priced. While QE3 has extended the rally in equities it has not helped stimulate economic growth as we’ve seen weak GDP numbers in 2013. It has kept interest rates low though and staved off any huge upward movement in the long-term interest rate.

Political Uncertainty Hampering Economic Growth

With the government shutdown and budget battle in which defaulting on our debt service was used as a bargaining chip, economic growth has stalled even more. Retail sales and consumer confidence dropped so the Fed’s decision not to taper in September looks a little more prescient. With the data they had, they decided it wasn’t the time to slow the amount of liquidity it was pumping into the economy. Because of the weak economic data and almost non-existent inflation, the Fed has been able to keep QE3 in place. Many investors and pundits cried foul when the Fed decided not to taper, but as it turns out, it may have been the right move.

Changes at the Fed

With Ben Bernanke stepping down as Fed Chair in January, President Obama has nominated Janet Yellen to succeed Bernanke, although she still must be confirmed by Congress. We believe, assuming Yellen replaces Bernanke, the tapering of QE3 won’t begin until March 2014 at the earliest. Given this, it’s highly unlikely that we will see the short to intermediate-term rates rise materially between now and then. Of course, much of it will also depend on what the language coming out of the Fed meetings will be. Bernanke is not likely to make any changes and will leave it to his successor to decide what to do about QE3.

The Fed also said it won’t raise the short rate that is near zero until the unemployment figure drops to 6.5%. Given the disappointing employment reports we’ve seen lately, it seems this is the correct move. However, one thing I am concerned about is that if the Fed waits too long to raise the short rate, they may end up doing so at the end of an expansionary economic cycle. This would be a big negative for the economy and the markets because the last thing you want to be doing is raising rates heading into a recession or the beginning of a contractionary period in the economy.

I still believe bonds prices will drop substantially, hurting any investor whose bond portfolio has a long duration. As the U.S. economy strengthens the rates have to go up. We believe any investor with a significant portion of their portfolio allocated to bonds will be best served with short to intermediate-term bonds. It seems the 10-year rate will remain in the 2.5% range until the Fed lets the free market determine the long rate. While this will almost certainly hurt bond portfolios, the beginning of the end of QE3 may very well turn out to be bullish for the economy. The yield curve will steepen, giving banks more incentive to loan. Banks borrow on the short rate and lend out at the long rate, so the greater the spread the more profit for the lender.

Putting it All Together
Interest rates will rise, there is little debate on that. However, there should be ample time for any bond investor to make any necessary changes before the market gets too far ahead of them. It will be important to pay attention to what the Fed’s language is coming out of their meetings. Any decision to begin tapering earlier than March 2014 will come as a surprise to the market and could cause interest rates to spike and possibly a correction in the equity markets. The probability of a surprise start to tapering seems unlikely in my opinion. Bond investors must stay diligent and watch what the Fed says, but I don’t see a bond market crash in the near-term as QE3 will most likely stay in place”.

 

by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.

Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

 

LiveJournalLinkedInEmailFacebookTwitterShare

Comments

comments

Leave a Reply

WordPress Themes