Bond bubble isn't bursting ... yetDecember 18, 2012: 12:26 PM ET
The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.
They say you can't fight the Fed. But the bond market is giving it the good old college try.
The Federal Reserve announced last week that it was expanding its current bond buying program and that it would keep short-term interest rates "exceptionally low" until the unemployment rate hit 6.5%.
In other words, the Fed is going to do everything it can to keep all sorts of bond yields low for a long time. We could be in the thick of the 2016 presidential race by the time the Fed decides to finally tighten.
Despite this, long-term bonds have sold off in the past week, sending rates higher. The yield on the benchmark 10-year Treasury note stood at 1.65% the day before Ben Bernanke unveiled QE4 (Or is it just QE ∞ at this point?) As of Tuesday morning, rates had risen above 1.8%. That's a pretty sharp move in a relatively short period time.
So is this finally the beginning of the bursting of the bond bubble? Many investors are preparing for rates to skyrocket.
"We've had a 32-year bull market in bonds and I think it's over," said Harry Clark, chairman & CEO of Clark Capital Management Group in Philadelphia. He thinks that over a period of several years, the 10-year rate will move closer to its historical average of about 4.5%.
But Clark is quick to note that the challenge is getting the timing right. There are many reasons to think that rates should head a lot higher than where they are now. However, with the Fed acting as a buyer of last resort, it seems unreasonable to expect a bond bloodbath like we had in 1994.
Clark said over the next 12 months, he doubts that the 10-year yield will move higher than 2.4%. And he said rates could possibly move back toward historical lows of near 1.4%.
In fact, that almost happened after the Fed unveiled QE3 in September. Rates quickly rose to almost 1.9% in mid-September but fell back to 1.56% by mid-November. Rates hovered around those levels until the recent spike following last week's Fed announcement.
So more volatility like this could be in the cards. It all depends on economic data. All it might take to spook the bond market and bring back recession or deflation fears is another really bad jobs report.
It's also worth noting that foreign investors still ♥ Uncle Sam. According to figures released by the Treasury Department Monday morning, both China and Japan increased their holdings of U.S. debt in October. They own a combined $2.3 trillion.
That just goes to show that no matter how silly it may seem that the Fed thinks it can print its way to prosperity, U.S. bonds are still viewed as better bets than the debt of many European nations. Even the partisan political stupidity surrounding the fiscal cliff negotiations is not enough to deter big foreign investors. At least not yet.
But make no mistake. Bond rates eventually have to move higher. Having all this liquidity sloshing around will one day lead to inflation. It's simple math.
"It's unsustainable for long-term bond rates to be below the rate of inflation forever," said Jerry Webman, chief economist with OppenheimerFunds in New York.
Webman said that the impact of each new round of QE on the bond market could be more limited.
"If you are tired and you drink more coffee in the morning it wakes you up. But by 5pm, if you drank too much you feel more tired. That may be happening with the Fed. The more bonds they buy, the less effect it may have," he said. (I can personally vouch for the caffeine part of that quote.)
So what should investors do now? Clark and Webman both think that it would be wise to start pulling back on bond investments. Each said they were worried by the fact that so many investors have been plowing into bond funds this year while dumping stock funds.
"The bond bubble hasn't burst yet. But when rates start to head higher, a lot of small investors are going to get stuck because so many of them have rushed into bond funds," Clark said.
Webman's warning is even more dire.
"Many investors could find themselves surprised to find out that what they thought was a safe investment turns out to be less safe," he said. "If everyone tries to reverse that at the same time it could be extremely disruptive. Those of us who remember 1994 knows what that feels like."
Heck, just look at what's happened to former Wall Street darling Apple (AAPL) in the past 3 months. That could be what the future of the bond market looks like.
Finally. A quick reader shout-out. While noting the big slide in shares of Meg Whitman-led HP (HPQ) on Monday, I asked Twitter followers to identify a song lyric I had quoted because it had Meg in it. College football freak Alex Ferguson is the winner!
We may have to have a friendly non-monetary wager related to next month's Notre Dame-Alabama national championship. I think the Irish will win. I suspect he disagrees given his SEC (as in Southeastern Conference and not Securities and Exchange Commission) leanings. But I digress.
Ha. It would be sadder if you had Binged it. Anyway, I miss the White Stripes. What Meg lacked in sheer talent, she made up for with brute force. She would have made John Bonham and Keith Moon proud. It's a good thing Jack White has his solo career ... and what seems like 342 other side project bands.