Monday, June 2, 2014

The meaning of the bond market rally

Along with the return of sector rotation, another favored strategy among investors lately has been the return of the long bond trade.  Treasuries have outperformed stocks in the last four months with the iShares 20+ Year Treasury ETF (TLT) adding 12% in the year to date versus only 5% YTD for the S&P 500 (SPX).  Bond yields by contrast have fallen steadily this year as bond prices have risen.

In prior years a bond market rally was considered a safe haven trade as investors flocked to the relative safety of bonds during periods of uncertainty.  At this point, however, much of the money flowing into bonds represents global “hot money” inflows as the promise of ECB President Mario Draghi to do “whatever it takes” to stimulate the EU economy has been followed by a loose money policy throughout much of Europe.  Investors currently favor U.S. Treasuries over European sovereign bonds due to perceived safety issues and relative yields.  An argument has been made that the U.S. is therefore benefiting more from Europe’s monetary policy than Europe is.

The big question is to what extent lower bond yields will push mortgage rates lower?  A decline in the 30-year fixed rate (see chart below) would undoubtedly boost consumer spending via home refinancing.  The lifting impact of the upcoming 60-year cycle bottom this fall could amplify this effect, assuming rates remained subdued until then.  The important thing to keep in mind for now is that the rising trend in bond prices and corresponding decline in yields should be viewed as a net positive for the economy rather than a negative.

[Excerpted from the May 30 issue of Momentum Strategies Report]