The bond vigilantes appear to have returned, punishing not only the Treasury market but also exacting a toll on the
highfliers. Will they return to their glory days and send stocks crashing, as they did in 1987?
Those old enough to have been around in the 1980s remember when this band ruled the markets, imposing penalties on what they deemed to be excessively easy policies that threatened to fan inflation. They would shoot first and ask questions later, pushing up interest rates and battering bonds and stocks alike. In those days, debt and equity markets would trade in sync, with bad news being good for both securities’ prices because it meant interest-rate relief.
What’s different this time is that the bond vigilantes are fighting the Fed, to mix two market aphorisms. The Federal Reserve just reiterated its intention to maintain its ultra-accommodative policy until it sees what it deems as maximum employment and inflation steadily above 2%. That policy calls for near-zero short-term interest rates and $120 billion a month in securities purchases.
During the great disinflationary bond bull market that began nearly four decades ago, the vigilantes eventually hung up their holsters, as yields moved to lower lows with each cycle, from a peak in 1981 over 15% for the 10-year Treasury to a low just over 0.5% last August. A gentle climb to 0.92% by the end of 2020 hardly caused a ripple for stocks.
The bond selloff already has been brutal. The
exchange-traded fund (ticker: TLT) returned nearly minus 14.89% this year through Thursday, according to Morningstar data. That loss reflects a rise in Treasury yields to levels still low in historical terms, 1.73% for the benchmark 10-year note and 2.45% for the 30-year bond. The moves essentially retrace their steep declines during the pandemic-induced economic contraction, which triggered the Fed’s vigorous easing.
So far, the broader market has held up, with the
posting another record by topping 33,000 on Wednesday. Financial stocks have benefited from rising bond yields and the more steeply sloped yield curve, while the Fed has anchored the short end with its 0% to 0.25% target for the federal-funds rate. The most widely watched measure of the latter, the spread between yields on the two- and 10-year Treasury notes, gapped out to 157 basis points, or hundredths of a percentage point, the most since July 2015.
That surge, accompanied by a near doubling in bond volatility, has rocked the most richly priced stocks, notably the big stay-at-home winners that had been bid up to valuations indefensible without the support of sub-1% bond yields.
Two ETFs tell the story: The
(QQQ), which tracks the 100 biggest Nasdaq nonfinancial stocks, had returned minus 0.54% for 2021 through Thursday and negative 6.14% over the past month. And
(ARKK), the poster child of the ultragrowth names led by
(TSLA), is off 3.55% this year, owing to a near-bear-market negative 19.52% return over the past month.
How much higher will longer-term Treasury yields go? And what will that mean for stocks?
For the near term, the trend in yields remains up, at least on a technical basis. Peter Tchir, head of macro strategy at Academy Securities, sees a further rise to 1.87% on the 10-year yield, which would put it near where it traded in late 2019 before the world was turned upside-down. A move to 2.10% is a realistic target, he writes in a client note, but a break above that could lead to a jump to the 2.50% range—where the benchmark note stood two years ago. But that would probably qualify as a “disorderly” move that could elicit a reaction from the Fed, he adds.
At his press conference on Wednesday, the central bank’s chairman, Jerome Powell, said the recent backup in longer-term yields didn’t necessitate a change in its bond purchases. Other central banks, notably the Reserve Bank of Australia, have adjusted their bond buying to try to quash rises in intermediate yields.
But more than a few observers think it’s time to fight the Fed and flee bonds. On his LinkedIn page, Bridgewater Associates founder Ray Dalio this past week issued a public report whose title posed the question: “Why in the World Would You Own Bonds?” That is, when they pay “ridiculously low yields.” Not only do these yields, which are negative in most markets around the world after inflation, fail to meet the needs of institutions such as pension funds, but bonds also can’t provide the diversification they did in the past, he adds.
Not so, avers Scott Minerd, global chief investment officer at Guggenheim Investments, in an investment note. The recent run-up in yields is typical of what happens early in an economic recovery; historically, those rises were later reversed. For instance, in the recovery from the Reagan recession, long-term government bond yields surged nearly 200 basis points, to 12%, starting in 1983, before retreating to about 7% by 1986.
History may rhyme again, Minerd says. There might be an initial surge in inflation from a burst of demand from an economic reopening and fiscal stimulus checks, which will probably meet supply bottlenecks. But, he contends, that will be temporary. Eventually, supply will catch up to demand.
While Minerd concedes that nobody can pick a top and doesn’t rule out a move to 2%-2.25% on the 10-year Treasury in the near term, Guggenheim’s models show that the market already is “stretched,” given the current uptick in yields. And the firm’s long-term historical model shows that yields could go lower, perhaps below 0%. Given this, the good news is that investors could own long bonds. But a descent to new lows would probably be a result of bad news for the economy or financial system, he writes.
The most proximate trigger would probably be a full-fledged equity bear market. That has been the history of recent decades, most notably on Black Monday, Oct. 19, 1987, when a rapid rise in long-term Treasury yields, to 10%, collided with a richly valued market trading at over 20 times expected earnings, resulting in a record 22% one-day plunge in the Dow.
More recently, a rise in the 10-year yield to 3% in late 2018 resulted in a drop just short of the bear market standard of 20%, leading the Fed to halt and later reverse its hikes in the fed-funds rate. It’s arguable that it wouldn’t take nearly so large a jump in yields to produce the disorderly overall financial conditions that might spur Fed officials to act, either by shifting their bond purchases to longer maturities or increasing them outright.
Before the bond vigilantes can take down the stock market, as they did in 1987, Powell & Co. are likely to head them off at the pass.
This coming week could see a reversal of fortunes, albeit temporary, between the bond and stock markets, as institutional investors rebalance their portfolios ahead of the end of the first quarter.
Corporate defined-benefit pension funds will move about $28 billion into fixed-income securities, the biggest inflow since 2009, according to an estimate by Wells Fargo Securities strategists Mike Schumacher, Zachary Griffiths, and Erik Nelson.
Pension funds typically target a particular asset allocation among bonds, stocks, real estate, and alternative investments. Periodic portfolio rebalancing automatically forces them to sell high and buy low. With long-term U.S. government and corporate credit returning a dreadful negative 11.2% so far in the first quarter, the debt portion would have to be topped up, write the Wells Fargo trio in a research note. U.S. debt securities constitute 47% of the funds’ holdings, making them their largest asset class.
The good news for pension funds is that the combination of higher stock prices and higher bond yields has dramatically improved their solvency. The strategists estimate that corporate defined-benefit plans are 96% funded, on average. That’s up 3.5 percentage points in March alone and is the highest figure since the solvency ratio hit 93% in October. Higher interest rates decrease the present value of future fund liabilities, while higher investment returns boost the funds’ asset side.
Individual investors take different tacks, seeking positive current real returns. Despite the uptick in Treasury yields, risk-free rates are likely to remain below inflation for the foreseeable future, writes Mark Haefele, UBS’ chief investment officer for global wealth management, in the bank’s monthly letter. That means they should look elsewhere for positive real yields, including in dividend stocks or riskier parts of the credit market.
The economic recovery should aid high-yield bonds, while the rebound in oil prices should also boost the energy sector, which makes up a big portion of speculative-grade debt, the letter adds. High-yield bonds also tend to be more resistant to rising Treasury yields as credit spreads narrow. The improved outlook for credit and potentially higher yields also favor senior loans, which usually have floating interest rates.
To follow the latter recommendation, our colleague Alexandra Scaggs offered a number of ETFs focused on floating-rate assets this past week. I also highlighted some leveraged closed-end loan funds early this year. They offer higher yields and trade at discounts to their net asset values.
Overall, UBS’ Haefele advises clients to “position for reflation.” That means continuing to emphasize value stocks, including energy and financials. They should keep playing catch-up after their underperformance last year, while small-caps should continue to outpace their bigger brethren.
While institutions reshuffle portfolios, it will be interesting to see what individuals do with their $1,400 stimulus payments. Some $242 billion was deposited into Americans’ bank accounts on Wednesday, the biggest “helicopter drop” to date, write Jefferies economists in a research note. At the same time, Bank of America strategists point out, a “staggering” record $68.3 billion flowed into equity funds in the past week. It seems that at least some of the stimulus may be going for speculation, rather than spending.
Write to Randall W. Forsyth at [email protected]