Download The 10-Year Yield Is A Whopping 4 Standard

The 10-Year Yield Is A Whopping 4
Standard Deviations From Its LongAverage
Lance Roberts, Street Talk LiveJUL. 9, 2013, 6:56 PM4,4122
Lance Roberts is the host
of "StreetTalkLive."
en.wikipedia.org - Douglas Fairbanks, movie star, speaking in front of the
Sub-Treasury building, New York City, to aid the third Liberty Loan.
I have been very vocal since the beginning of June that now is a
great time to be adding bonds to portfolios. (See here and here)
There are several fundamental reasons for my belief that the
recent rise in interest rates was more related to a short term
liquidation cycle rather than a shift in global economic sentiment.
1) Domestic economic strength remains very weak (growing at
just 1.8% annually since 2000)
2) Four years into the current "recovery" the economy is already
past the average length of most growth cycles. Interest rates fall
during down cycles.
3) Geopolitical unrest makes U.S. Treasuries an attractive "safe
haven" for foreign capital flows.
4) Global economic weakness (China, Euro-zone and Japan) will
likely drive buying of U.S. Treasuries.
5) Upcoming "debt ceiling" and budget debate in September
likely to drive inflows into the safety of bonds as we saw in 2011.
6) If the Federal Reserve begins to extract liquidity by slowing
bond purchases - financial markets are likely to come under
selling pressure pushing money flows from equities into bonds.
7) Declining rates of inflation which are representative of
economic weakness.
8) Ultra-low interest rate policies by the Fed continue to push
investors to seek yield over cash. The recent rise in rates makes
bond yields much more attractive.
However, even if you disagree with the fundamental arguments, it
is hard to argue against one of the most compelling reasons for
buying bonds which has 35 years of history supporting it. I
discussed this particular reason during a Fox Business interview
recently stating that:
"Interest rates are now 4-standard deviations above their long
term moving average."
As shown in the chart below the driving force behind the long
term decline in interest rates has been the ongoing slide in both
economic activity and inflationary pressures. Interest rates track
the direction, and trend, of economic activity as does inflation.
Less demand in the economy leads to declines in prices
(deflation) and interest rates.
There are two important things to take away from the chart above.
The first is that, as I have notated with blue arrows, is that each
time interest rates have spiked it has led to a peak in economic
activity. You can already see that economic growth has peaked for
the current economic cycle which has led to a subsequent decline
in inflationary pressures. Secondly, most of the commentary
surrounding the reason that rates are on track to go higher is
based on the the similar spike seen in 1994. First, that spike in
rates led to a sharp slowdown in economic activity and rates
quickly fell. Secondly, the economy was in the midst of a secular
growth cycle due to the "Internet/financial boom" which
currently does not exist today.
The next chart, however, is the "technical" reason as to why I
think now is the time to start acquiring bonds. Again, you can
argue the fundamental story, depending on how you want to
selectively build your economic "case", however, it is difficult to
argue with 35 years of interest rate history. The chart below shows
the 10-year treasury rate on a weekly basis with bands set at 4standard deviations above and below the 50-week moving
average. The green shaded area is the current downward trend
that has remained intact post the interest rate spike in the late
70's.
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What is important to notice is that there have only been a few
times in history that rates have gotten to 4-standard deviations
above the long-term moving average. Every single time, as noted
by the vertical red dashed lines, such extreme movements in rates
has been a peak in rates for the intermediate term. Most recently
these extreme spikes were witnessed prior to the recession
following the "technology bubble" in 2000 and the "housing
bubble / financial crisis" in 2008.
The blue shaded area at the bottom of the chart shows the current
range of interest rates that are likely to occur given the context of
the downtrend. The peak of that range is 3% on the 10-year
treasury and the bottom of that downtrend would suggest rates on
the 10-year during the next recession to fall below my current
estimate of 1%.
There are many reasons to own bonds in portfolios as they have a
capital preservation function by returning principal at maturity,
creating an income stream and lowering portfolio volatility.
However, there are three reasons to add bonds to portfolios
currently:
1) As discussed recently investors tend to do the opposite of what
they should investment wise by panic selling market bottoms and
buying market tops. Currently, unlike the stock market which
remains extremely overbought on an intermediate term basis,
bonds have had a substantial correction in price which now
makes them technically very attractive in the short term for a
trading opportunity.
2) The "quest for yield" isn't over as long as the Federal Reserve
continues to keep "accommodative rate policies" in place that
keep money market rates near zero. With "baby boomers"
rapidly heading into retirement, following two nasty bear
markets that took away 50% of wealth, the allure of "safety" and
"income" are the keys to their current psyche.
3) Money flows into U.S. Treasuries will likely increase as the
slowdown in European, and Asian, economies seek safety and
stability of the U.S. As pointed out by Jeff Gundlach, manager of
Doubleline Total Return Bond Fund, recently reiterated the same
call stating:
"The liquidation cycle appears to have run its course with
emerging market bonds, U.S. junk bonds, muni's and MBS—all of
which substantially underperformed Treasuries during the rate
rise—now recovering sharply,"
With the reality that the economy has likely peaked for this
current economic cycle, deflationary pressures rising and the
potential for less monetary interventions in the quarters ahead the
catalysts for higher bond prices are tilted in investors favor
currently. As I stated previously:
"Investors are panic selling what is likely an intermediate term
bottom in bond prices and holding onto to equities in what is
clearly one of the most overbought, valued and extended markets
since 2000 or 2007. While the mainstream market analysis
continues to tout 'buy and hold' strategies - statistical evidence
clearly weighs in favor of a rather significant correction at some
point in the not so distant future. While timing of such an event is
difficult at best, given the extreme amounts of artificial
intervention by Central Banks globally, the impact to investors
portfolios devastate retirement plans."
For all of these reasons I am bullish on the bond market through
the end of this year. Furthermore, with market volatility rising,
economic weakness creeping in and plenty of catalysts to send
stocks lower - bonds will continue to hedge long only portfolios
against meaningful market declines while providing an income
stream.
Will the "bond bull" market eventually come to an end? Yes, it
will, eventually. However, the catalysts needed to create the type
of economic growth required to drive interest rates substantially
higher, as we saw previous to the 1980's, are simply not available
currently. This will likely be the case for many years to come as
the Fed, and the administration, come to the inevitable conclusion
that we are now in a "liquidity trap" along with the bulk of
developed countries.
While there is certainly not a tremendous amount of downside left
for interest rates to fall in the current environment - there is also
not a tremendous amount of room for them to rise until they
begin to negatively impact consumption, housing and investment.
It is likely that we will remain trapped within the current trading
range for quite a while longer as the economy continues to
"muddle" along.