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Since the beginning of the year, our pension fund clients have become increasingly worried about a sharp selloff in the bond market.They’ve seen yields tick up, heard the warnings of Pimco’s Bill Gross and have watched Warren Buffett issue $2.6 billion in long-term debt despite Berkshire Hathaway’s mountains of cash.
All point to a bond market bubble reaching its breaking point.
Investors don’t know exactly when that bubble will burst, but most seem to agree that bond prices simply cannot go much higher. But what could a bear market in bonds actually look like and how do investors take advantage of it?
While the last 30 years have been generally bullish for bonds, they have experienced intermittent bear markets, defined here as a 15 per cent price decline from peak to trough, several times. Indeed, since 1980, seven such bear markets have occurred with the first starting in 1980, then repeating in 1981, 1984, 1987, 1994, 2000 and 2009.
These bear markets typically manifest themselves in two different ways: One where the Federal Reserve sparks the selloff by raising rates to cool an overheated economy and one in which the market itself starts the selloff with no Fed action on rates until later, if at all. Both have very different results for nearly all asset classes.
The Market Led Selloff (The Likely Scenario Now)
In a big bond market selloff not caused by the Fed raising rates, the yield curve steepens and long-term bond prices plummet. Stocks and other “risk” assets, on the other hand, typically skyrocket in this scenario. During the three periods when the market sparked the selloff, the S&P 500 rallied an average of 26.33 per cent. The biggest stock surge came in 2009 when the S&P 500 rallied 44.8 per cent, but it also increased by double digits in 1984 and 2000.
Around the globe, stocks rallied as well. The Stoxx, a key European stock index, rallied an average of 24.72 per cent during market-led bear markets and the Japanese Nikkei stock index averaged 26 per cent returns during those periods.
Commodities also benefitted as higher interest rates typically meant higher inflationary expectations and a corresponding uptick in the GSCI Commodity index. During these types of bear markets, the commodity index rose an average of 26.23 per cent. Meanwhile, the response by world government bond markets, as reflected in the WGBI index, weakened right along with the U.S. bond markets.
Given the Fed’s recent statements about keeping rates low through 2015, this scenario is most likely in the next bear market. Indeed, many believe bond prices could fall as much as 25 per cent this time around.
Fed Led Selloff
When the Fed sparks a bond selloff, bond prices tend not to fall as far and the corresponding rise in equities is less pronounced. Tight Fed policy reduces inflationary expectations and the rise in yields mostly occurs in short-term bonds. This is best illustrated in the period October 1993 through January 1995, when the yield curve flattened dramatically. The reason for this is simple: The Fed typically encourages a bear market in bonds when it believes the economy is overheating and it wants to tame inflation. In some cases, such as in 2005, Fed policy actually diminished inflationary expectations so much that bond yields decreased just as the Fed raised short-term rates. In such cases, the Fed’s move wasn’t even enough to spark a bear market in bonds.
When the Fed was the first to move, the rise in stocks was much less dramatic than a market led selloff in bonds. Under this scenario, the S&P 500 averaged a gain of just 1.92 per cent, the European STOXX index dropped an average of 0.95 per cent and the Nikkei rose 12.43 per cent. Meanwhile, with the Fed actively trying to slow economic growth, commodities gained an average of 12.78 per cent.
Global government bonds, on the other hand, actually strengthened while their U.S. counterparts continued to head south.
capitalising on the “Bear Market” in Bonds
This time around, it’s fairly clear that the market, not the Fed, will lead any near-term bear market in bonds. The Fed has said it will maintain a policy of low interest rates to spur growth and employment, a policy that seems to be working, albeit slowly. Given this case, smart investors should aggressively buy “risk” assets such as U.S. and global stocks, especially in emerging markets where credit quality tends to improve during these times. Commodities, and other assets denominated in dollars, including real estate should also perform well. Foreign bonds, just like U.S bonds, will be losers, but playing for a steepening long-term yield curve in the U.S., and the rest of the world, is also a strategy that will yield benefits.
While it might seem too early to put on such positions because the bond market is not yet in bear territory, the question is when it will get there. The dreaded “Sequester,” continued weakness in the Eurozone and questions surrounding China’s ability to continue its pace of economic growth could all slow the economy down. But the likelihood is that bonds are in the midst of a bear market and prices could easily fall more than 20 per cent.
The day will come when the Bernanke Fed will not only stop buying bonds but will also begin to sell all the bonds they’ve accumulated over the past four years. The 30-year Treasury bond is already more than six per cent from its highest price and the Chinese and other foreign investors will soon grow tired of paltry coupons, a weakening currency and endless supply. Maybe it is time they increase their stock and commodities holdings instead, and sell those bonds before nobody is left to buy them.
Jay Feuerstein is the CEO ad Chief Investment Officer of 2100 Xenon, an investment firm based in Chicago. He has held senior investment positions at Bear Stearns & Co., Kidder Peabody and Drexel Burnham Lambert.
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