Market Surveillance — Bond Yields Define Gravity

Thurs, MAY 29th, 2014

Nope. That is not a misprint. Defy does not fit. I actually mean define, in the literal sense of the word (per Google).

De·fine /diˈfīn/

1. State or describe exactly the nature, scope, or meaning of.

That is precisely what bond yields have done this year, they have defined what gravity is — the force of attraction by which things tend to fall (inward).

So what gives?

My take on the current gravitational forces keeping yields lower (in no particular order):

Hedge against uncertainty, particularly geopolitical unrest in the Ukraine as Russia plays the bully and political tensions in Turkey, Thailand, Venezuela and other emerging markets have increased investor anxiety.

Pension funds shifting allocations at the margin after years of solid stock returns (the capstone being the +30% rally in 2013), which left many funds more flush on the asset side of the ledger while future liabilities have been reduced due to an increase in market interest rates (~1.6% on the 10-year to ~2.5% currently). As a result these fund managers have the latitude to take less risk to achieve their performance goals.

Lower quantity of Treasurys as the federal deficit falls (expected to be under $500B this year, the lowest level since 2008). If the U.S. Government is borrowing less (i.e., lower deficits) then fewer bonds are issued. Simple.

Meanwhile, the demand side is healthy. The Fed is still buying large amounts of bonds, even as they taper. In addition, the aging population means a greater demand for bonds as the Baby-Boomer wealth preservation phase replaces decades of wealth accumulation. This is a strong secular, demographic trend.

Lower bond quality, globally. U.S. Treasurys (10-year) gets you a yield somewhere between 2.5%-3.0% (throughout the balance of 2014) with a full faith and credit seal. At the same time, in Europe investors can get German bunds, UK gilts, Spanish, Italian and French bonds anywhere between 1.3%-3.0% (Germany’s the lowest, Italy the highest). Bunds are about -120 basis points lower than comparable U.S. Treasurys; that’s not terribly inviting. And why would any rational investor buy an Italian bond with all of their economic and fiscal troubles when you can get a lower risk U.S. Treasury with a similar yield? Risk/reward is completely out of balance. Japan is even less attractive at ~58 basis points for a 10-year JGB. Canada is ~2.2%.

Add to the prior point the notion that the ECB may further ease policy next week making U.S. paper even more attractive on a relative basis (i.e., the Fed is normalizing monetary policy while the ECB continues to loosen).

Inflation has not been and is not presently a threat. This improves the overall attractiveness of bonds as an investment. In fact, many central banks around the world (the Fed included) seem more focused on battling disinflation and even the specter of deflation as opposed to the threat of overheating economies.

A widespread sense that stocks are now overvalued and have run too far. This, coupled with some of the above items, have resulted in recent net fund flows moving into bonds pushing prices up and yields down.

Lower Treasury yields are the market story of the year (so far). Once again financial markets have done a fantastic job of confounding the masses. When Treasurys hit ~3% at the end of 2013 most analysts thought we would be at ~3.5% by now on the way to ~4%. And while they will probably be correct in the fullness of time, for the past ~6 months the bond market has done exactly the opposite. This is causing much hand wringing in the investment community. It is also prompting many — incorrectly in my estimation — to infer that the bond market is signaling a fundamental economic slowdown.

As I have persistently stated, from my perch the preponderance of macro data suggests otherwise: jobs figures, leading indicators, rail & truck loads, private consumption data, household net worth, rising yet tempered confidence, etc. all show an encouraging trajectory. This view discounts the economic perspective. If price confirmation of financial assets is more your speed (vs. economic data) you need not look any further than the relative out-performance of cyclical stocks including the Dow Transports, up nearly +10% on the year. If you believe that bond yields are signaling an economic slowdown (or worse-yet, recession), what are these cyclical and transport stocks telling us?

All told, lower bond yields against the backdrop of stable and improving economic fundamentals are a good cocktail for stocks. Indeed, at a ~2.5% 10-year with an upside range to, say, ~3% (and conversely elevated prices) I still want to be in stocks at those yields. This environment also keeps credit cheap, which is good for the economy. Too, general economic growth is supportive of sales and profits and thus stock prices. Finally, valuation on the stock market remains sensible across most measures, save for the CAPE ratio and market cap-to-GDP — though both metrics have their issues and neither implies impending doom at current quotations.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.