Long Bonds Slump


A back-up in bond yields has fueled worries that a global bond bubble could burst, which could trigger sharply higher interest rates and undermine the rationale for today's elevated stock valuations.

The financial press attributed much of the bond-market volatility to statements from Federal Reserve officials — and related worries that the Fed might lift short-term interest rates on Sept. 21, after its next meeting.

The Fedspeak may have jolted some investors, especially those convinced bond yields and inflation will remain low for a very long time. But, at less than 20%, the market-implied odds of a Sept. 21 rate hike are little changed since Sept. 9, when rate worries broke the stock market out of its summer torpor. Moreover, the bonds most sensitive to Fed policy, like two-year Treasury bonds, have seen their yields rise less than those of 10-year and 30-year bonds.

In fact, the yield spread between short- and long-term bonds has widened steadily over the past two weeks, reflecting rising long-term yields in Japan and Germany. At the end of July, disappointment with inaction by the Bank of Japan triggered a sell-off in long-term government bonds. Early this month, the European Central Bank disappointed investors.

Both central banks are working on potential policy changes. Some figure the new policies will be less friendly toward long-term bonds, partly because of worries about the damage negative interest rates are doing to banks and other financial companies.

Stock-market impact

As you'd expect, the back-up in bond yields has weighed on bond-like stocks. The utility, telecom, and consumer-staples sectors have been the worst performers this quarter. More worrisome has been the impact on other sectors, with cyclical stocks hit on worries about the potential impact on the real economy.

Whether they reflect a bubble, central-bank manipulation, or reasonable expectations for a low-inflation environment, today's low interest rates are helping rate-sensitive industries like autos, building supplies, homebuilders, and capital goods. They also make it easier for companies of all kinds to repurchase shares — one of the biggest sources of demand for U.S. stocks since 2012.

Stocks remain attractively valued compared to bonds. But such comparisons assume corporate earnings growth will return to historical norms — a big assumption given the recent slowdown in profit growth.

We'd like to see the Dow Transports and other cyclical stocks rally if bond yields keep moving higher. That would suggest yields are rising on signs of economic strength rather than central-bank policy changes — and it would suggest investors are gaining confidence in the outlook for corporate earnings.

A close above 8,109.19 in the Dow Transports would put the Dow Theory in the bullish camp. For now, reflecting two downgrades this week, we're keeping 19% to 22% of our buy lists in a short-term bond fund.

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