The moniker conjures up an image of sinister figures clad in ninja-like garb, creeping stealthily through the dark in pursuit of their objective: wreaking havoc on global financial markets. But the Bond Market Vigilantes, whose possible responsibility for the plunge in Treasury securities during May has everyone in the financial markets buzzing, are really nothing more than finance geeks with an obsessive interest in exploiting discrepancies between bond prices and what they feel are the fiscal realities of the governments issuing those securities.
Moreover, even if they have been pushing Treasury bond prices lower and yields higher in recent weeks, that doesn’t necessarily spell doom and gloom for investors. It may only mark the beginning of a new kind of market environment – one that most of us should have been preparing for already.
Bond vigilantes certainly exist, even if they haven’t – as so many have warned since the financial crisis – turned the U.S. into another Greece (because the U.S. is fundamentally different from Greece and the E.U.). These speculators have a tendency to focus their laser-like attention on pockets of the market where they figure fiscal policy is a problem and yields don’t reflect reality. Most recently, they have popped up in Europe, driving yields on sovereign debt in some corners of the Eurozone to sky-high levels until European Central Bank head Mario Draghi announced last summer that the ECB would do whatever it took to preserve the continent’s common currency. Now, the big selloff in bonds is fueling anxiety that the vigilantes may have finally shifted their focus to the Treasury market in an attack on what they see as risky tactics by Fed chair Ben Bernanke in keeping U.S. interest rates so very low for such a long time.
Let’s stop for a moment to look at where the U.S. economy stands. Whether it is because of those low interest rates or simply because the financial and real estate crises of 2008 are receding further into the past, the economy is slowly strengthening. Wages may not be climbing, but unemployment levels are falling; the economy is growing, even if it isn’t at a heated rate. Consumer confidence is rising; retail sales, if not robust, are in positive territory; the housing industry recovery continues apace. All of this has fueled anxiety among investors that there is a mismatch between the Fed’s insistence on holding rates at their crisis lows until unemployment falls to 6.5 percent – perhaps another two years – and the picture of the economy that the data presents.
A Toxic Inflationary Death Spiral?
Odds are that the ranks of those who believe all this monetary stimulus will ultimately lead to some kind of toxic inflationary death spiral include some bond market traders or speculators, who have decided that now is the time to act on those convictions by selling Treasury securities or shorting them. But is there a de facto alliance of global speculators with the common aim of driving interest rates higher? And should it matter to your portfolio?
No and no.
Conspiracy theories are comforting, if only because they help explain what otherwise may feel like irrational and irrationally volatile market movements. Bond investors have every reason to worry about what is happening in the Treasury market, and grasping why they may have decided to act on that anxiety in the last five or six weeks doesn’t require a conspiracy theory.
It has been clear from the outset that investing in Treasury securities at ultra-low yields wasn’t going to be a risk-free scenario. How could it be? Sure, bond yields did creep lower, from 1.8 percent to 1.7 percent and below on the 10-year Treasury, but few investors in their right minds could have expected that downward trend to continue as the economy slowly stabilized. Even in a slow-growth economy with relatively high unemployment, the disconnect between yield levels and the economy was evident. The one thing that Treasury investors needed to do was to ensure that they were neither too early nor too late in selling.
What seems to have happened is that last month’s apparent ambivalence and uncertainty among Fed policymakers, combined with the economic news, has produced a “Goldilocks moment” for bond investors: not too hot, not too cold, but just the right time to sell. And, as is the case in any market and asset class, at some point, the selling pressure becomes a self-fulfilling phenomenon as momentum kicks in.
Just as there is no evidence of a vigilante-style conspiracy at work (however tempting the mental image of a bond vigilante creeping along, Hamburglar-style, with a swag bag over one shoulder) so there is no certainty that this jump in yields is the beginning of the end of the great bull market for Treasury securities.
As Birinyi Associates recently pointed out, since the equity market selloff ended in March 2009, there have been five other times when the 10-year bond’s yield has climbed a similar amount or even more, none of which have proved lasting. True, the current move is off some of the lowest yields on Treasury securities ever recorded, and at a point in time when the economic data suggests that a yield of 2 percent or higher might be more appropriate than one closer to 1.5 percent, but markets aren’t always logical.
And if this is the beginning of the end for bonds? Well, it doesn’t have to be the end for your portfolio. If you happen to own Treasury securities, one hopes that you didn’t buy them for their yields or their long-term potential for capital appreciation, but more as a safety cushion or hedge. Hold them to maturity, and you’ll still get your principal back and collect whatever meager coupon payment the Treasury promised. (Anyone who has held on to their Treasury holdings for the last two years in anticipation of outsize capital gains and who believes that the ten-year should trade to yield about 1 percent probably shouldn’t be allowed to manage his or her own money.)
While the pros have been itching to short the bond market for years, describing it as more overvalued than the most bizarrely priced dotcom stocks at the height of that bubble, investors may not want to respond in a knee-jerk manner by selling. Examine your rationale for holding Treasury bonds, and whether it is still intact. If it is, close your eyes and ears to the volatility and noise, and focus on the long term and your overall asset allocation.
If the bond market selloff does continue, be prepared for a lot of volatility across all asset classes, as investors and speculators jostle to establish a “new normal.” Expect much of the turmoil to be seen in the world of corporate bonds, and especially among junk bonds, where yield spreads have become compressed. Odds are that these lower-quality issues will see not only an absolute gain in yield but a widening of spreads, as investors reconsider the question of credit risk.
Uncertainty for Stocks
When it comes to stocks, however, the picture is far more uncertain. Here, the reason for the selling pressure matters: Are bond market bears dumping their Treasury holdings because they think the government’s finances are in an even greater mess than they previously did, or because they think the Fed has changed its policy stance, or because the economy is in better health than previously believed?
In this case, it’s likely to be the third answer that is most relevant. If anything, the federal government’s position is better than expected: The Congressional Budget Office recently calculated the budget deficit will be significantly lower than previously forecast. When it comes to public pronouncements, Bernanke has shown no signs of a fundamental change of mind or heart. If anything, it’s the gap between what is happening to the economy and those Fed policies that lies behind the bond market selloff.
Ultimately – once the uncertainty and volatility is behind us – that could be good news for stocks. A stronger economy means higher corporate profits – and higher stock prices and valuations. As Goldman Sachs’s portfolio research team argued to clients at the end of last week, the reason for the move in bond yields “will support higher” valuations and fuel some cyclical and interest-rate sensitive sectors of the market. (They recommend overweighting financials and industrials stocks.)
Just don’t expect this scenario to play out tidily and calmly. As we have already witnessed, with all the breathless speculation about bond market vigilantes being at work, the reversal of the Great Bond Bull Market isn’t going to be a quiet and effortless process, but likely will only be achieved with a lot of noise, anxiety and volatility.