January 9, 2013

Is the Bond Bear Market Finally Here?

U.S. Treasury yields declined on news of fiscal cliff resolution and worries that Fed’s QE4 will end soon

The broad high-quality bond market began 2013 on a sour note with a sell-off, posting its worst weekly performance since March 2012, as U.S. Treasury prices declined on news of a fiscal cliff resolution, LPL Financial’s bond expert reported Tuesday.

While LPL doesn’t believe the sell-off is the start of a sustained move higher in interest rates, bond yields are likely to remain range-bound, wrote LPL Market Strategist Anthony Valeri in a note, “Sour Start to New Year.” Further, he said, LPL continues to favor higher-yielding segments of the bond market to avoid more interest rate-sensitive sectors.

“Optimism over recently passed legislation to narrowly, or temporarily, avert the fiscal cliff boosted economic growth expectations and concerns that the Fed may end bond purchases as soon as mid-2013 both weighed on high-quality bond prices,” Valeri wrote.

He explained that the yield curve, which measures the differential between short-and long-term Treasuries, steepened notably as the bond market priced in prospects for better economic growth.

“Price declines and a 0.10% to 0.23% increase in intermediate- to long-term Treasury yields had investors asking whether the long-awaited bond bear market had finally arrived,” Valeri said.

Bond analysts have been warning for the past year that interest rates are at their bottom, and bound to rise as soon as any signs of inflation in the U.S. economy set in. Bond prices and bond interest rates move in opposite directions. When rates rise, prices fall because a bond’s value decreases.

Valeri said LPL does not believe that the last week’s market performance signals the start of a sustained sell-off or long-term higher interest rates in the bond market.

“The current episode, if it continues, is more likely to resemble the short-lived pullback of March 2012 and a similar period of weakness in October 2011,” he wrote.

In a review of last week’s two market drivers — the release of minutes from the Dec. 13 Federal Open Market Committee meeting and the fiscal cliff deal — Valeri pointed to the FOMC statement that several policymakers “thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.”

With the Federal Reserve’s bond purchase program now in its fourth round of quantitative easing, investors should not be surprised to see the Fed end bond purchases sometime in 2013, Valeri said.

“Prior purchase programs, such as QE1, QE2 and Operation Twist contained elements that varied in length from six months to just over one year,” he wrote. “At some point, the Fed will have to slow or end bond purchases. Most importantly, Treasury yields actually declined following the end of prior Fed purchases programs, as investors believed the markets were not strong enough to stand on their own. A slowing or an end to bond purchases does not necessarily translate to a rise in bond yields.”

Read PIMCO’s Gross QE4 Warning: Here Be Inflationary Dragons at AdvisorOne.

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