Reasons for the Bond Rally

I know, I know – Who cares about the reasons? Only Price Pays! 

But still, as professional investors, understanding the reasons behind a trend is every bit as important as respecting the market action itself. I live and work in a world of pragmatic mediums, not ideologically pure extremes.

Anyway, most of the market is baffled by the rise in bonds this year and the plummet in rates. As Joe Terranova (Virtus Investment Partners) relates in his SALT Conference wrap-up, this is the year’s biggest question mark – even for the savviest investors:

Clearly the prevailing theme is the question of why the U.S. 10-year Treasury yield is below 2.50%. Quite candidly from the many views that were offered, we can call it the “grand mystery” of 2014 – nobody seems to know why, which is a surprise to the overwhelming majority, including myself.

My suspicion is that “behavioral finance” might be more important in 2014 than earnings or the macro environment. The consensus on each asset class and individual stocks is wrong and pivoting to reposition and adjust weightings accordingly. That is creating confusion and the absence of a clear “tailwind theme” for a particular asset class for the first time in many years.

Anyway, Doug Kass has put together as good a list of reasons for the action in bonds as I’ve seen anywhere. Here’s what he thinks is going on:

Several reasons why the (beginning-of-the-year) consensus expectations of rising fixed-income yields continue to be wrong include:
  • Liability-driven pension plan buying.

  • The Federal Reserve has “cornered” the Treasury note and bond markets – resultingly, available supply has dwindled.

  • There is a developing correlation (over the near term) between rising bond prices (and lower yields) and declining equity prices. So if a stock market correction develops, bond prices will likely climb (and yields will likely continue to contract).

  • Evidence that the important housing sector continues to pause and the continued ratcheting down of domestic economic growth forecasts for the first six months of 2014.

  • Competition from surprisingly low European yields, as the European Central Bank considers the start of a broad-based asset purchases and other conventional and unconventional easing policies.

  • Demographic trend support (as the maturing baby boomers seek the safety of income).

  • The failure of trickle-down economics to support the stead of the middle class (who are still experiencing only modest income gains).

  • Fear that accelerating inflation — the CRB index is up 11% year-to-date — will impede growth.

  • Rising fear of geopolitical risk (now in the Ukraine) is putting a flight-to-quality bid under bond prices.

  • Growing evidence that the recovery in Japan’s and China’s economies are more muted than previously expected.

By the way, that word “resultingly” is made up, like “impactful.” If it catches on, Dougie should get the credit.

I can find something to agree with in all of this stuff.

I’d also add that a lot of financial advisors probably caved in to pressure from their clients at the end of last year when bonds dragged their performance back versus the S&P 500. “Why are we bothering to own any bonds at all?” I dealt with that kind of inquiry at the end of last year so I can only imagine that everyone else did as well, to varying degrees.

This means there’s probably some asset allocation money chasing the rally in bonds after people made a big portfolio mistake at the end of 2013.


2014 SALT Conference (Virtus)

Doug Kass (TheStreet)