Is the Great 30 Year Bond Bull Market Over?
Is the Great 30 Year Bond Bull Market Over?
Recently, interest rates have begun to creep up as the U.S. economy appears to be improving. Corporations are earning record profits, housing is showing some life and consumers appear to be spending more on things ranging from clothes to autos. Since the beginning of December, 2012 the yield on the 10 year U.S. Treasury has risen from about 1.6% to 2% as of February 16th. So what does this all mean? Is the 30 year bond bull market on the ropes?
Chart of the recent yield of the U.S. 10 year Treasury Bond.
Origins of the Great Run in Bonds
Let’s take a look back at the origins of this long bull market in bonds. The great bond bull market of the last 30 years had its roots back in the late 1970’s and early 1980’s when inflation was running 9% to 11% a year. Paul Volcker became the Federal Reserve Chairman in 1979, and his goal was to slay inflation by raising interest rates to restrict the money supply which had been very loose for most of the 70’s. Volcker succeeded in taming inflation by raising interest rates on the federal funds rates on which most bank borrowing is based. By raising interest rates very high (the 10 year treasury rate went above 15% for a time) Volcker was able to squash inflation, but in so doing he helped cause a very severe recession.
For the next 30 years interest rates for the most part have been in a steady downtrend, all the way to where the 10 year yield on a U.S. Treasury Bond is around 2%. For bond investors this has been good news because bond prices move inverse to interest rates. Inflation for the most part has remained relatively benign for the last 30 years and with Fed Chairman’s Greenspan and now Bernanke holding interest rates low for so long in an attempt to revive the economy, rates and bond yields continued their long slow decline to where we are today. The Federal Reserve has also bought a lot of Treasury Bonds the last several years via its Quantitative Easing (QE) program. This has kept demand for bonds high and kept rates down as well. Finally, Americans continued to pare down debt and boost savings. A lot of this money ended up finding the bond market as investors sought high quality debt, especially with the 2 brutal bear markets in stocks the last 12 years that devastated portfolios. Also, anytime there was a flare up of problems in Europe, money found its way to the “safe haven” of U.S. Treasury bonds, which pushed prices up and rates down.
The past 30 years were great for bond investors, because falling rates and tame inflation are a recipe for above average returns for bond investors. However, as mentioned above, there are some signs that interest rates may be headed higher as the economy improves and more people are finding jobs. If you look very closely at the chart below, you can almost make out the increase in interest rates over the last few weeks. Looking at it in the long term, this recent rise is just a small blip, and over the last few years there has been many small “blips” when rates increased temporarily. Economists have been wrong over and over again the last few years predicting that rates had to go up. Will they be right this time? Remember a stopped clock is right twice a day, so there is a chance.
Chart of Yield on the 10 Year U.S. Treasury Bond since 1977. Recessions are shown in grey.
So for over the last several years, falling interest rates have been good news for those looking to get a mortgage or re-finance a mortgage, or to borrow money since these rates are generally tied to the rate of the 10 Year Treasury. However, in the last few years it has been miserable for savers and retirees looking for safe interest income. Money market accounts which just 4 or 5 years ago were paying 4% are now paying virtually nil. Those looking at Certificates of Deposit (CD’s) have noticed that those rates are miserable as well. Even going out 5 years on a CD will find you struggling to get 1.5% these days.
Why Would Rates Rise Now?
There are a number of reasons interest rates could rise over the next few years. First, an improving economy with a housing market on the mend and more people finding employment should make it easier for modest inflation to show up. Second, Ben Bernanke has pledged to keep interest rates low for a long time, but in December, 2012 refined that pledge by setting specific targets. Now he has stated that interest rates will be kept low until unemployment falls below 6.5% and inflation tops 2.5%. Unemployment is currently just under 8% but has been steadily dropping and inflation is running at around 1.7% currently. Both of these events could conceivably happen in the next several months and would set the stage for the Fed to end the QE programs and possibly start raising short term interest rates.
Finally, as interest rates have become so low in the highest quality areas of the bond market, more money could possibly flow into stocks as people realize that stocks may give them a better chance for better returns over the next decade. Especially, when you consider the average dividend yield of the S & P 500 is about 2.5% which is higher than a 10 year Treasury, plus you have the chance for significant appreciation in price in stocks, and not so much in bonds. If demand for bonds decreases because of this, bond prices would fall and rates would start to go up.
Why Would Interest Rates Remain Low?
If rates are to rise, a lot will depend on the economy. If the economy doesn’t continue to improve and we do fall into a recession, than unemployment will likely remain high and inflation would likely be pressured lower. If this happens rates may continue to stay low, and bonds could continue to provide decent returns for some time yet. Bernanke would continue QE programs for a long time and continue buying Treasuries and rates would remain low.
You could argue that rates could still go quite lower. Consider the fact that the Japanese 10 year Government Bond currently yields 0.75% and has had a very low yield for a very long time, as Japan has struggled to generate higher interest rates for many years. Now, there are a lot of differences between Japan and the U.S., so I am not saying that this is what will happen to bond yields in the U.S., but it is worth noting that yields could still go a fair amount lower from the current 2% yield on the 10 year Treasury.
One other thing to consider is that bull markets, whether they are for stocks, bonds, housing or tulips, generally end when there is euphoria about the asset class. Just remember internet stocks in 1999, housing in 2006, and Tulips in the 1600’s, although, I don’t think anyone living today remembers that one. Right now, it seems just about everyone hates bonds, and generally that is not the type of behavior that investors exhibit near the end of a bull market run. So although rates are due to rise, will it happen now, or could it still be a few years away?
So What Now?
In the next article we will get into some other issues that rising rates may affect:
• What effect will rising rates have on bonds or bond funds?
• Credit Risk versus Interest Rate Risk.
• What are TIPS, and will they help if rates rise?
• Are bonds still a part of a diversified portfolio?
• How do you generate income in these conditions?