The Not-So-Rosy Reasons Behind Bond Market Rally

Outside of the Clinton Administration, some people are beginning to take a less than glowing view of the fantastic bond market rally that began last week--and continued unabated Tuesday.

While the President and his advisers say the drop in long-term interest rates is a ringing endorsement of their economic plan, Wall Street worries about something else: That lower rates are a harbinger of another recession, or at least a pronounced economic slowdown.

If you figure that the economy will lose momentum under the weight of Clinton’s proposed tax hikes, after all, it’s also a good bet that demand for money will drop, leading to lower interest rates. So you’d want to lock in bond yields today.

At the same time, you probably would shun stocks on the expectation that slower growth would mean disappointing corporate profits.

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One long-time stock bull, Goldman, Sachs & Co. investment strategist Steven Einhorn in New York, says it’s no coincidence that stocks have been dead in the water for the last week, even as the yield on 30-year Treasury bonds has plunged from 7.14% to a record low 6.82% on Tuesday.

“The bond market is running on the assumption of a slow economy,” Einhorn asserts. Stock investors, meanwhile, are rummaging around to find some reward in the Clinton economic plan, but are coming up mostly empty-handed, he says.

The personal and corporate tax hikes that Clinton has proposed will unquestionably be a drag on the economy by slowing spending, Einhorn says. But perhaps more worrisome is the overall theme of the Clinton program, he adds.

“Look at the venom directed toward the health care (companies),” Einhorn says. “That’s not a backdrop that allows for a pleasant equity market. What it all says is that Washington now is a negative for stocks.”

Einhorn says he didn’t come to this decision lightly. Indeed, he has been one of Wall Street’s biggest bulls since 1990. But with the details of the Clinton plan last week, Einhorn changed his recommended asset-allocation model for clients from 70% stocks, 25% bonds and 5% cash to 55% stocks, 40% bonds and 5% cash.

“What I basically said was . . . that bonds would do quite well from here, while stocks weren’t going anywhere.” Though the Clinton Administration has argued that the drop in long-term interest rates should largely offset the economic pain of higher taxes (as consumers and companies refinance debt), Einhorn doesn’t buy it. There won’t be a new recession, he says, but the economy will definitely slow.

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For the average investor, Einhorn’s forecast presents something of a quandary. If stocks overall will be dead money this year and perhaps into 1994, bonds seem to make more sense--especially if you assume that yields will drop further.

Yet the bond rally has been so powerful over the last week that many pros say the market has reached the panic-buying stage. That suggests yields are being artificially depressed and could snap back to more attractive levels in spring.

In part, the T-bond rally is a result of big investors desperately switching out of mortgage-backed bonds, such as Government National Mortgage Assn. issues, says James Midanek at Montgomery Fixed Income Group in San Francisco. As interest rates drop, more homeowners are expected to refinance their mortgages--which will retire high-yielding GNMA bonds well ahead of schedule.

So big investors are trading GNMAs for T-bonds that don’t face a prepayment threat.

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Certainly, though, many investors are buying T-bonds purely because they expect a slower economy ahead and because the yield advantage in owning long-term bonds remains substantial compared to short-term securities.

But as the accompanying chart shows, that advantage is narrowing: At 6.82%, the 30-year T-bond is 3.82 percentage points above the 3.00% discount rate on six-month T-bills. Last October, the yield advantage in the 30-year bond was a stunning 4.54 points over the six-month bill.

With low inflation, aren’t long-term yields still attractive? Probably, says William Gross, strategist at Newport Beach-based Pacific Investment Management, a major bond investor. But Gross, who correctly championed the idea of buying long-term bonds all through 1992, now says he’s closer to selling bonds than buying more.

“The atmosphere is getting a little thin,” Gross says. This bond rally “reminds me of the last-gasp effort on the part of nervous buyers.” Remember the buying frenzy that accompanied the peak in the NASDAQ stock market earlier this month?

If you want to own long-term bonds (individually or via mutual funds), Gross suggests waiting. More than likely, some political or economic event will send 30-year T-bond yields above 7% again, perhaps by this spring. That’ll be the time to buy, he says--not now, when the crowd is busting down the door to get in.

Going Long: The Benefit Drops

As long-term interest rates drop while short-term rates hold steady, the yield benefit of buying long-term bonds is falling though it’s still large. Yield advantage, 30 year T-bond over six-month T-bill:

1992 Jan.3: 3.56 April 3: 3.68 July 3: 3.97 Oct. 3: 4.54

1993 Jan.3: 4.11 Feb. 3: 3.82