The bull market in Treasuries is encouraging complacency in US investors but, with the economy growing at 3%, interest rates may be about to rise
One year after the terrorist attacks on the World Trade Center and the Pentagon, most financial commentary is focused on whether stocks have bottomed.
What's missing right now is any meaningful discussion of whether interest rates have seen their lows for the cycle.
True, the two questions are opposite sides of the same coin.
Treasuries have been trading inversely with stocks for several years. The post-11 September environment just exacerbated the trend. In the last six months, the Standard & Poor's 500 Index has moved in the same direction as the 10-year note yield (opposite direction to prices) more than 92% of the time. The correlation between the S&P 500 and two-year note yield is 95%.
Still, what's unique to this particular cycle is that no one contemplates an end to the Federal Reserve's extended period of low interest rates, which would be curtains for the bull market in Treasuries. Is anyone making a bearish bet on interest rates?
'We're not there yet,'' says Jim Capra, president of Capra Asset Management. 'But you can't make a lot of money from the long side.'' In order to do so, 'you have to believe the US is going into a deflationary spiral like Japan''.
Plenty of people do. The best-case scenario is an economy that struggles with sub-par growth for several more quarters.
The worst case, as Capra suggests, is a double-dip recession or multiyear depression. In both cases, the Fed is viewed as out of the picture for the short, intermediate and, in some cases, long term.
'When I look at the June 2003 eurodollar contract and see it trading at 2%, it seems the market is too complacent,'' says Paul DeRosa, a partner at Mt Lucas Management Co.
The implied yield on June eurodollar futures, which reflects expectations for three-month interest rates nine months from now, touched a low of 1.9% last week, which suggests the overnight federal funds rate will still be at its current 1.75 in the middle of next year. (Three-month rates key off the funds rate.)
The fact that there is such a one-sided bet on interest rates should be a call to arms for contrarians, says Jim Bianco, president of Bianco Research in Chicago.
'There's a healthy debate on the stock market bottoming, with powerful evidence on both sides,'' Bianco says. 'There's no debate about the bond market. There's a universal view that there is no inflation, that yields are going down because stocks are going down.''
If the one-sided nature of the market isn't enough to energise contrarians, consider some historical facts.
When the bull market in bonds started in October of 1981, with 30-year yields at 15.21%, 'the 20-year average rate of return for bonds was 2.4%,'' says Paul McCrae Montgomery, a money manager and market analyst at Legg Mason Wood Walker in Newport News, Virginia, citing data from Ned Davis Research.
In November 2001, with bond yields at 4.79%, 'the 20-year total return was 13.1%,'' he says. 'People are used to good returns from a safe place to hide from the stock market. But bonds are going to be a poor investment going forward.''
Economists recognise that interest rates are at levels inconsistent with a healthy, growing economy. It's the 'healthy'' and 'growing'' that are missing.
It might not feel like it, but 'the economy is growing at 3%,'' says Jim Glassman, senior US economist at JP Morgan Chase. 'The economy is much more resilient than anyone thought, given all the shocks. When the shocks fade, interest rates will be found to be too low for a healthy functioning economy.''
The absolute level of interest rates makes a bullish bet a bad idea at this point.
'When the historical odds since 1925 are 0% that bonds will outperform stocks over the long run, it suggests a considerable risk for someone making a long-term investment in bonds versus stocks,'' says Ned Davis, president of Ned Davis Research in Nokomis, Florida.
Bloomberg newsroom, New York
$17trn of debt is now ‘paying’ a negative yield
47 million Brits without financial advice
Faces substantial prison term
General election on 12 December