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Bye, Bye Bonds?
New York: March 26, 2012
By John Stephenson

Strategic Investor – March 26, 2012 – Bye, Bye Bonds?

One of the surest money making trades may be coming to an end. For more than three decades bond buying has been an investment no brainer. Since 1981, a bull market has been raging in bonds, rewarding investors with both capital gains and interest payments. Yields on 10-year U.S. Treasury notes, the world’s bellwether fixed-income security, peaked at 15.8% in September 1981 and fell to a low around 1.7% last September—capping a stupendous bull market in bonds. Ever since, yields for the U.S. 10-year note have traded in a narrow range from 1.8 to 2.1%.

The easiest way to gauge the strength of the bond bull market is through yields, which move inversely to prices—when yields fall, it means bond prices are rising. And for more than thirty years bonds have been on fire.

But last week, something unusual happened that has some declaring the end of the bond bull market. Last Monday, yields on the 10-year U.S. Treasury notes suddenly surged to 2.4%, a move considered dramatic by bond market standards. Last Wednesday, Goldman Sachs made a gutsy call that it was time to rotate into stocks from bonds, because returns were likely to be better. The Goldman report concluded that “The prospects for future returns in equities relative to bonds are as good as they have been in a generation.”

With the American economy appearing to have turned the corner, consumer sentiment has been on the rise since August of 2011. The situation in Europe, while not resolved, is at least contained for now causing investors to bid stocks higher. The S&P 500’s 10% climb in the first 55 trading days of 2012 is the best start since 1998. And around the world, Hong Kong’s Hang Seng Index is up 13%, Brazil’s Bovespa Index is up 16% and Germany’s DAX Index is up 22% year-to-date all in U.S. dollar terms. Even with these dramatic upward moves by markets, the S&P 500 is still historically very cheap with a dividend yield of 2.03% (including the new Apple dividend).

If improving economic conditions in the U.S. stick and the Federal Reserve backs off on any further talk of quantitative easing, or money printing, look for yields on the 10-year to march higher. Another catalyst for higher yields could be a sustained upturn in inflation. The 10-year Treasury note could easily hit 3% or more by year end. In fact, it was as high as 3.73% in February of 2011.

Bond yields could also move higher if China, the biggest buyer of America’s biggest export—its IOU’s denominated in dollars—stops buying. That would leave the Federal Reserve as lender of last resort to fill the gap left by its biggest creditor. Beijing has made no secret of its desire to diversify away from greenback assets—mainly U.S. Treasuries. According to the Wall Street Journal, that’s already happening with U.S. dollar assets comprising 54% of Beijing’s $3 trillion-plus reserves as of last June 30, 2011, down from 74% as recently as the end of 2006.

There’s an $800 billion gap between the $1.1 trillion the Treasury is borrowing to cover the budget gap and the roughly $300 billion overseas investors are buying. The U.S. so far has benefitted because other countries needed dollars as reserves and for transactions. No other market has the same depth and liquidity as the U.S. financial system, the linchpin of which is the Treasury market. But, when the Fed discontinues its assets purchases of Treasuries and allows the markets to resolve the shortfall in demand, rates on bonds will move higher.

And while the long bull market in bonds looks a little long in the tooth, a sudden flare up of Europe’s sovereign debt problems could cause investor to pile into U.S. Treasuries in a flight to safety—driving yields down and prices up.

Last week, reports of slowing Chinese steel demand and concerns over an unexpected drop in the Chinese purchasing managers index (PMI) saw stock markets come unglued. This uncertainty impacted the currency markets with most currencies, losing ground to the U.S. dollar. Especially hard hit was the Aussie dollar, whose fortunes are closely tied to growth in China.

The waves of “risk on, risk off” behavior that has dominated stock markets over the last year appears to be slowing. Investors are increasingly beginning to look toward company-specific valuation metrics rather than simply focusing on risk levels of broad asset classes. The S&P 500 Implied Correlation Index, a measure of the degree to which prices of stocks are likely to move in lock step, has fallen from a record high of over 80 back in December, to as low as 65 recently—suggesting greater returns for stock pickers. The bond bull may not be completely dead, but it’s best days behind it. With cash yielding nothing, investors who are comfortable delving into stock specific issues are likely to be better rewarded for their efforts.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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