Is the Boom in Bonds Over?
Interest rates surge as surprisingly strong economic growth sends the bulls fleeing
Through bull markets and bears, and in good economic times and bad, there's been one wonderful constant for investors and consumers over the past quarter century-long-term interest rates kept falling. The dramatic decline helped make stocks more valuable and houses more affordable.
But all good things must come to an end. And it looks increasingly as if this unprecedented financial ride may be over. The yield on the 10-year treasury note spiked as high as 5.32 percent last week, marking a five-year peak in interest rates. Just a month earlier, treasury yields were as low as 4.63 percent. Of course, it is difficult to predict the future direction of rates. And at week's end, bond yields gave back some of their gains. But "the only thing we have to go on is the trend," says Marilyn Cohen, chief executive of Envision Capital Management. "And it seems like we've broken the long downturn in rates."
The three-decade bull market in bonds had many fathers. In the 1980s and '90s, bond prices rose and 10-year yields (which hit 15 percent in the early '80s) fell as inflation was squeezed out of the economy. At the same time, growth became steadier as America shifted from highly cyclical manufacturing to more stable services. Investors became more confident about the economy's future stability, justifying lower risk premiums and lower yields.
In addition, the end of the Cold War and the spread of capitalism globally created what Federal Reserve Chairman Ben Bernanke calls the "global savings glut." Foreigners now own more than 44 percent of the U.S. national debt. More recently, investors flocked to long-term government bonds, fearing an economic slowdown. The net effect of the bond boom: a welcome tail wind to consumers, the economy, and the financial markets.
Now some of the biggest names in finance think that tail wind has blown itself out. William Gross of PIMCO, the nation's most influential bond fund manager, says that 10-year yields could reach 6.5 percent in the next three to five years. Last week, former Federal Reserve Board Chairman Alan Greenspan hinted that long-term rates might keep rising as global liquidity dries up.
Placing bets. Rates have been surprisingly low for some time, given the strength of the global economy, market watchers say. The flood of money pouring into treasuries (keeping rates low) is likely to ebb as foreign central banks raise short-term rates to stabilize growth. What's more, bond traders had bet big that the housing slowdown would spill over into the broader U.S. economy and perhaps spur recession. This led to a buying binge of treasuries.
But "the bond market got it wrong," says Jack Ablin, chief investment officer for Harris Private Bank. After growing at an anemic annual rate of 0.6 percent in the first quarter, the economy is now expected to expand more than 3 percent in the second. Spooked by the economy's unexpected reacceleration, those bond speculators rushed to the futures pits to unwind their bets.
But don't connect the rise in rates to increasing inflation. David Nolan, portfolio manager of the BB&T Mid Cap Growth Fund, says recent trading in the commodities market isn't reflecting that. Neither is recent activity among Treasury Inflation Protected Securities, or TIPS bonds. "This wasn't an inflation scare," says Tobias Levkovich, chief U.S.equity strategist at Citigroup Investment Research. "It was a change in growth expectations."
As a result, the jump in interest rates could actually coincide with a rise in stock prices since stronger economic growth is likely to give corporate profits another shot in the arm. To be sure, rising rates will mean investors will have to be more judicious about the assets they invest in, since higher borrowing costs will eventually slow growth. But in general, "the markets are waking up to the realization that the economy is proving better and more sustainable than expected," says market strategist James Paulsen of Wells Capital Management. And as long as inflation doesn't surface, "how can that be bad for stocks?" he asks.
This story appears in the June 25, 2007 print edition of U.S. News & World Report.