Must Bond Yields Rise?
Brian Reynolds
Over the last few months, we've detailed how Treasury bonds have become one of the most disliked investment classes not only by fixed income managers, but also by both equity bulls and bears. The almost universal dislike for Treasuries really became apparent to us earlier this week when we saw a brokerage analyst on TV describing how rising yields will impact the industry he covers. He used the phrase "as interest rates rise" as a preface to describing the hurdles that his companies face, as if either rates were rising now, or are certain to in the near future.
It seems that we've heard that phrase used with increasing regularity by the brokerage community, as there is strong sentiment that the Fed will raise short-term rates this year and that Treasury yields will go up. We ran a search on Google's News feature and found 37 stories that were published in major newspapers and news services in just the last month containing the words "as interest rates rise".
So, the sentiment towards rising yields also seems to have crept into the mainstream media. That would be fine, except that Treasury yields have basically been flat since September, with the 10-year Treasury having traded in a narrow channel of between 3.93% and 4.45% during that time, with yields actually having fallen over the last month to the lower end of that range.
We have expressed no love for Treasuries at these levels; we think they offer little fundamental value here and, with yields at the bottom of a trading range, it would not be surprising to see them bounce up within that range, especially after this morning's CPI number.
However, investors must also think about the possibilities that would lead to lower bond yields. We have been writing with increasing frequency about how inventories have been increasing in recent months as production has outpaced consumption. While extra-high tax refunds may give spending a little boost in the spring, we think that at least a moderation in production (or even a modest decline) will be needed to mitigate the growing level of inventories.
Any moderation in production would be likely to produce worries about an economic slowdown (are we the first to use the term "triple-dip"?) which, in the past, have sent investors scrambling to buy bonds. At a minimum, it would prolong the time that the Fed would remain on hold, perhaps much longer than the Fed Funds futures market now implies. The longer the Fed remains on hold, the more likely it becomes that investors will continue to respond to any bounce up in Treasury yields by putting on the "carry trade"; buying long maturity bonds funded by borrowings in the short-term markets and pushing yields back down.
Should the 10-year yield sharply break below the 3.93% level, mortgage refinancings would surge again, and mortgage investors would be likely to ramp up their mechanical buying of Treasuries (pushing yields even lower) that they use to hedge themselves against higher prepayments in a repeat of last year's buying frenzy.
If the yield on the 10-year does plummet, the impact on stocks will then be heavily impacted by the action in corporate bonds. The plummeting of Treasury yields was a disaster in 2002 for stocks because investors were buying Treasuries as they were fleeing from corporates; the negative action in corporates more than offset the benefits of mortgage refinancing. We wrote last year that the spring 2003 drop in Treasury yields was likely to be good for both the economy and stock prices, because it was the first time in more than 5 years that both corporate and Treasury bond investors were applying stimulus simultaneously.
However, this plays out, it appears that a drop in Treasury yields is not something that many investors are placing high odds on, so it may be beneficial to examine that scenario and its implications. |
