Monday, August 20, 2012

Have We Seen the Lows in Bond Yields?

Two events have happened in the markets recently that have surprised many analysts and strategists.

First, the stock market has continued to rise, albeit on very low volume.  The S&P 500 has risen by more than +4.4% this quarter, and is now up +14.4% for the year. Corporate earnings may not be spectacular, but they are good enough for now, at least.

And, second, interest rates have also risen sharply.  After reaching a low of 1.43% in mid-July, the yield on the 10-year Treasury note has jumped nearly 40 basis points over the last 4 weeks, and now stands at 1.82%:

The rise in U.S. interest rates has been matched by similar increases around the world.  German 10 year rates, for example, now stand at just under 1.5%, up 40 basis points from mid-July.

Now, to be sure, interest rates remain remarkably low by historic standards, and it can be argued that the recent rise in rates is a modest correction of the very sharp bond rally that started in mid-March.

However, it is also possible that perhaps we have seen the low in interest rates, at least for this cycle.  This is question that Merrill Lynch's chief global strategist Michael Hartnett address in his most recent weekly write-up.

Hartnett titles the path of the 30 year Treasury bond yield as "The Most Important Chart in the World" and gives his reason why:
The 30-year Treasury yield has bounced off the 2.5% level, as it did in 2008. If the 30-year Treasury yield has truly marked a secular double-low of 2.5%, as rising US real estate prices show that low rates are finally working, then the world of asset allocation is about to be turned on its head by The Great Rotation.  
I'm not totally convinced that we've seen the lows in interest rates, however.  Most bond observers use the 10 year Government yield as a benchmark for bond market direction, not the 30 year bond, for example, but Hartnett certainly makes an interesting point.
Meanwhile, individual investors continue to flee the stock market in favor of bonds.  Investors last week redeemed almost $6 billion in equities, mostly in favor of bonds ($4 billion inflow).
If interest rates continue to rise, investors in longer maturity bond mutual funds will start to feel some serious pain as the values of their "safe" holdings move ever lower.