Bill Schmick: What was behind the big surprise with bonds?
At the beginning of the year Wall Street was certain that interest rates were on their way up. Investors dumped all kinds of bonds anticipating that prices would plummet. Bond prices did the upset. Go figure.
The reversal caught just about everyone by surprise (including me). The thinking behind the bond call was straightforward. The Fed announced it was winding down its stimulus program. It also planned to begin raising interest rates sometime in 2015. Bond players, as they usually do, were expected to anticipate that move and begin to sell U.S. Treasury bonds this year. It all made total sense from an investment perspective. It was the end of a 30-year bull market in bonds so investors were advised to sell.
What few had foreseen in the first half was a slide in the European economy and a rise in geopolitical risk. Those conditions have effectively trumped any move by the Fed. Here’s why.
Consider that America and its sovereign debt have long been considered a safe haven in time of global risk like today. So as ISIS makes inroads in the Middle East and Putin thumps his chest in Europe, it stands to reason that global investors would buy U.S. bonds but there is more at work here than that.
Bond investors do not operate in a vacuum, especially when it comes to sovereign debt. They compare (price shop) the perceived safety of one country and what its debt is yielding against other countries and buy the best deal. This week, Euro zone yields on sovereign debt have fallen out of bed due to slowing economic conditions. The bet is that things are getting so bad that their central bank will have to take further easing actions in the weeks ahead.
So let’s say I’m a global bond investor. The 30-year U.S. Treasury bond is yielding a shade above 3 percent while the German 30-year is yielding 1.7 percent and the Japanese 40-year bond is offered at 1.8 percent. Why would I buy the German or Japanese paper when I could get more return in the U.S., which, by the way, is also a safer investment in a faster-growing economy? Even at the present low rate of interest, American sovereign debt is a much better deal than offshore sovereigns.
It also explains why we are seeing both the U.S. stock and bond markets moving in the same direction. As interest rates drop and yields get lower and lower, the return from the stock market looks better and better versus what one can get in the bond market. Clearly, lower interest rates are bad for savers but great for stocks and equity investors. I know that I wouldn’t be willing to settle for a 3 percent return over 30 years in a bond when I can get twice that in stocks, but some risk-adverse investors certainly would.
In this kind of environment, fears of what our own Fed may or may not do a year from now is definitely on the back burner. As we close out the last days of summer this Labor Day weekend, the stock markets are once again hitting new highs. Fewer and fewer strategists are looking for pullbacks of any magnitude. All seems right with our markets while the rest of the globe seems to be falling apart. Too much complacency, probably, but it is what it is.
Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Schmick’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Schmick at 1-888-232-6072 (toll free) or e-mail him at Bill@afewdollarsmore.com.
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