Author: Robert M. Freeman
The following views and opinions do not necessarily reflect those of the Keiter Stephens Hurst Gary and Shreaves or Capital Advisory Group.
John Maynard Keynes, a well known British economist, once said that “The market can stay irrational longer than you can stay solvent”, which has proved to be true over and over again. Perhaps the best example of this was the tech bubble of the late 1990s, when forward PEs (price to earnings ratios) climbed from the historical averages of about 15 to 17 to over 26 at the peak in early 2000. As the PE ratios rose to higher and higher levels many were tempted to short the market (bet that it would decline), which in some cases cost them dearly as the market continued to rise.
It appears that we are looking at a similar situation today with Treasury Bonds, which have been bid up in price reducing their yields to near historic lows. Apparently, most bond investors aren’t aware of the risk inherent in the fixed income markets, as FINRA (Financial Industry Regulatory Authority) discovered in a recent survey that over 79% of investors did not understand that bond prices decline as interest rates rise.
In an August 18th Wall Street Journal article entitled “The Great American Bond Bubble,” Jeremy Siegel describes the risk that many bond investors appear to be missing. He points out that while about $232 billion dollars left stock funds in the first 6 months of the year, bond fund inflows have totaled about $559 billion dollars. Although this is not surprising to me in light of the dismal stock market performance over the last decade, it will likely end badly for many of these bond investors. As Siegel points out in his article (at which point the 10 year treasury was yielding 2.8%, compared with the current yield of 2.61%) a rise in the yield to 3.15% over the next 12 months would result in no return as the decline in price would offset the coupon payments. In addition, if rates rose to 4%, an investor who purchased the bonds at the 2.8% yield would lose about three times the coupon payment.
However, since the market can stay irrational, betting on rising yields at this point may be a dangerous game. Based on the weakness of recent economic data, it is possible that the Federal Reserve will attempt to push rates even lower in the coming months. Given the current political climate and upcoming election, it is unlikely that Congress would be interested in additional stimulus spending even if the economy continues to weaken. So, it will likely be left up to the Fed and its range of monetary policy tools. Unfortunately, there may not be much that the Federal Reserve can do, as additional quantitative easing is likely to have a limited effect; the primary problem is not the cost of credit, but the deflationary effects of a lack of aggregate demand.
In summary, Treasury Bonds are overpriced by most measures, but could go higher (pushing yields down further), if the economy continues to slow or contract. However, it is likely that over the next several years, inflation expectations will increase, pushing up bond yields and forcing down bond prices. Unfortunately, this likely to be an unhappy surprise for many investors who were seeking the “safety” of investing their money in Treasury securities.