Bonds Are Still a Buy
The demand for US bonds is not going away anytime soon.
Indeed, there has been a growing fear regarding just how and when the Federal Reserve will begin to normalize its monetary policy through the elimination of quantitative easing and an increase in short-term interest rates. We will get two important clues this week: On Wednesday, the minutes from the latest FOMC meeting will be released, and on Friday, monthly jobs data will be reported. Both have the potential to cause a sharp market reaction, but neither are likely to change the long-term trend of higher rates. But in the near term, bonds may still provide opportunistic trading opportunities from the long side.
Market observers have been forecasting the rotation out of bonds and into stocks for a while. We are finally getting data to suggest that the great rotation is underway. It began in January as money flows into stocks began outpacing those going into bonds for the first in years. It then kicked into high gear in May and June as talk of taper spooked the markets. Bond funds saw a record of some $70 billion in net outflows during that two-month period, causing one of the largest spikes in percentage terms in yields across the fixed income market. There was a brief hesitation while stocks sold off in unison before the money began flowing into the equity market.
But given that, there are a variety of factors at work that suggest not only that there won’t there be a mass exodus, but that near-term dips in bond prices (increase in yield) might present buying opportunities.
It’s Still a ZIRP World
The Fed has made it abundantly clear that short-term rates, beginning with the Fed Funds overnight lending rate, will remain near zero until at least the end of 2014. While the curve could steepen a bit more, it will keep long-term rates anchored near historical lows. And the US is not alone; worldwide central banks are following similar monetary policies. And despite their extraordinary efforts, global growth is anemic, and there is barely a whiff of inflation.
Indeed, this seems to be the backbone to the bullish call made by two of the biggest and most respected bond fund managers. Both Jeffrey Gundlach of Double Line Capital and Bill Gross of PIMCO turned bullish on bonds in mid-June, right in the midst of talk about tapering. A tad premature -- and maybe still a bit underwater -- but not proved entirely wrong yet.
Many have opined that a tapering of quantitative easing, which currently stands at $85 billion per month of bond purchases, will in effect be a tightening. But it should be noted that any taper is a far cry from eliminating the purchase, or the unthinkable selling, of bonds. The Fed will continue to gobble up supply and control a majority of the market impacting the supply/demand equation. While traditional investors are coming around to the decision that a 10-year bond yielding a bit over 2% might not be worth the risk, there are host of institutions that are simply not interest-rate-sensitive. In the wake of the financial crisis, pension funds and individuals with a long-term horizon are now focused on capital preservation and will keep a certain percentage of assets allocated to “risk-free” bonds just to get their principal back.
But an important and somewhat underreported source of demand comes from financial institutions that need to post collateral to lubricate lending and their associated trading activity. Bloomberg estimated that through June, there was a need for some $900 billion to $2 trillion on a daily basis of high-grade collateral needed to secure swap and other interest rate derivative trades that are settled through clearing houses. Treasuries are the favored form of that required collateral.
The $633 trillion derivatives market is not going away anytime soon, and neither is the demand for US bonds. If yields on the 10-year move toward the 3% level this week, I would view that as a buying opportunity, and not a sign to jump ship, as rates will likely tack back down in the ensuing months.
For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.