There’s a potential serious problem shaping up
Last year was not only an unusual year for the stock market, but also for bonds.
It’s no secret that as the interest paid on bonds (the yield) declines, the prices of bonds rise. That’s because if you own a bond that pays you a yield of 6%, and new bonds being issued are only paying 4%, investors will pay more for existing 6% bonds to obtain the higher yield.
In the opposite direction, when bond yields rise, the price of bonds decline.
So last year provided a dramatic contrast in that regard between U.S. Treasury bonds, and corporate bonds.
As the economy slowed, risk increased that corporations might have problems meeting their debt obligations, raising the risk of bond defaults. So corporations were forced to increase the yield they offered on newly-issued bonds in order to attract investors. Those rising yields drove the price of existing corporate bonds down.
The result was that the prices of investment-grade (A-rated) corporate bonds (and bond mutual funds that invested in them), declined 6.5% for the year. Medium grade (BBB-rated) corporates were down 9.4% for the year. And the prices of high-yield bonds (formerly known as junk bonds) plunged 27%.
However, on the other side of the Street, two forces worked to drive the yield on U.S. Treasury bills and bonds in the opposite direction.
In its belated efforts to stimulate the slowing economy, the Fed drove interest rates down to historically low levels. Its most recent rate cut, in December, lowered the Fed Funds target rate to 0.0% to 0.25%, a record low, close to zero.
Meanwhile, after the stock market plunge to its October and November lows, investor confidence in the safety of their assets reached levels of fear not seen since the 1930s. They pulled money out of stocks, mutual funds, money market accounts, even bank savings accounts and CD’s, and poured it into U.S. T-bills and bonds at a panicked, never-before-seen pace. That increased demand also drove bond prices up, and yields down so low that six-month T’Bills are paying an annual interest rate of just 0.25%.
All of the spike-up in bond prices took place in November and December, after the stock market hit a new low in November. But it was quick and dramatic enough that the Merrill Lynch Treasury Bond Index, previously flat for the year, closed up 15% for the year.
However, let’s look ahead to 2009. There is a potential serious problem shaping up for Treasury bonds. In their spike-up parabolic rally in November and December, I believe bonds entered a dangerous bubble.
If I’m right, as we all know about bubbles, once they burst the decline is almost always an equally abrupt decline back down to normal levels. For bonds that could be a double-digit loss from current levels.
What could be the catalyst for a sharp reversal in U.S. Treasury bonds?
Actually, there are several.
Let’s begin with the stock market rally off its November low. So far the S&P 500 has gained 23% off that low in less than two months. I expect the rally will continue for several more months, possibly even until the beginning of the market’s next ‘unfavorable season’ in April or May, (although I’ll be watching the charts and technical indicators closely).
As I have been pointing out since our buy signal on the market, just a normal bear market rally that retraces 50% of the market’s decline before the downside resumes, would be as much as a 50% rally for the S&P 500. If I’m right, at what point will previously panicked investors, being paid record low yields to hold the bonds, begin to realize the profits they’re losing out on in the stock market, and bail out of bonds just as suddenly as they panicked into them?
Then there is the big increase in the supply of bonds that is likely, as the Treasury has to raise its debt levels to fund the humongous bailout packages. We all know what an increase in supply of anything does to prices.
And then there is the ‘big picture’ worry that has been around for years. When will Japan, China, and other world powers that hold such a high percentage of U.S. bond debt, decide soaring U.S. government debt has become just too risky, and move some of those assets out of U.S. bonds and into other global assets?
It may be too early to take a downside position against bonds right now. Going short a bubble while it’s still rising can be costly, as they can go on longer than anyone anticipates.
But it’s not too early to get ready, by investigating holdings designed to produce profits when bond prices decline.
Among them are the Rydex Inverse Gov’t Bond Fund, symbol RYJUX, which is designed to go up when 30-year bond prices decline. Then there are a couple of leveraged inverse ETF’s designed to go up twice as fast as the price of bonds decline. They are the ProShares UltraShort Lehman 7-10 year Treasury ETF, symbol PST, and the ProShares UltraShort Lehman 20+ year Treasury ETF, symbol TBT.
Something to be watching anyway as 2009 gets underway.
Sy Harding is president of Asset Management Research Corp., editor of Sy Harding’s Street Smart Report, and has been consistently ranked in the Top-Ten Timers in the U.S. since 1990 by Timer Digest. Sy publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beating the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!