Optimism on Rise, Bonds May Yet See a Turnaround
Investors who’ve been waiting for a convincing sign that longer-term interest rates are peaking--at least temporarily--may have gotten it on Tuesday.
When the Treasury offered $17 billion in three-year notes to the public, the response from small investors was extraordinary. “Non-competitive” purchase orders for the notes, the kind of order usually submitted by individuals, totaled $1.45 billion.
In contrast, $846 million in non-competitive orders came in for three-year notes at the last such Treasury auction, in February.
Back then, three-year notes were yielding about 4.7% annually. Now they pay 6.5%. To a significant number of small investors, 6.5% must look like an attractive yield if they’re willing to be stuck with it for the next three years.
That’s exactly the kind of change in psychology that the bond market needs to stabilize, after more than three months of surging interest rates.
And while individual investors buying T-notes can’t turn the bond market around by themselves, they may soon get more help. There are indications that foreign investors also have decided that U.S. rates have reached levels too attractive to pass up.
The dollar’s value rocketed Tuesday versus key foreign currencies, which bond traders said was in part the work of foreign investors buying dollars to use for Treasury bond purchases.
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While the dollar was falling between January and last week, foreigners had no incentive to buy U.S. bonds, because every drop in the dollar devalued U.S. assets held by foreigners.
But now that the Clinton Administration has decided to defend the currency, foreign investors can see a double-barreled payoff in buying U.S. bonds if the dollar is in an upswing: They can lock in decent yields, plus get the gift of price appreciation if the dollar keeps rising.
David Rosenberg, who runs the Oppenheimer U.S. Government Trust bond mutual fund in New York, is one pro willing to bet that the turn in the dollar also signals that bond yields have reached at least a near-term crest. On Tuesday, he bought some 10-year Treasury notes, yielding about 7.3% annually, for his $325-million fund.
Rosenberg believes that the latest sharp jump in long-term yields, which occurred Friday in response to the strong April employment report and resultant inflation paranoia, represented the kind of capitulation often seen when market moves reach the “blow-off” stage. “People were throwing up their hands,” he said.
And on Monday, Rosenberg noted, many professional traders jumped on the gloom bandwagon, “shorting” Treasury bonds ahead of the three-year note auction Tuesday and today’s planned Treasury auction of 10-year notes. In a short sale, traders sell borrowed bonds, betting they can replace them with cheaper bonds later on.
When bonds appreciated Tuesday (as yields fell) instead of depreciating as the shorts expected, some of the shorts were forced to buy bonds on the open market to cover their wrong-way bets. Combined with genuine demand from small investors and the sudden buying interest on the part of foreigners, the bond market rallied.
But can this rally stick? Each time bond yields started to pull back in recent months, more “bad” news came along (usually in the form of healthy economic reports) that reignited worries about inflation returning as the economy expands.
Thus, to be bullish on bonds now, you have to assume that yields have reached a level that takes into account almost any additional signs of economic expansion imaginable in the near term.
That appears to be the view of individuals buying three-year T-notes at 6.5%. The next group that must be convinced consists of Rosenberg’s peers, U.S. bond fund managers.
Patricia Bannan, manager of the Phoenix Balanced fund in East Hartford, Conn., is a case in point. Short-term “cash” assets make up nearly 25% of her fund’s $2.8 billion total. Of the rest, 45% is in stocks and 30% is in bonds. If she were to decide that rates had peaked and that bonds were attractive, she’d have lots of cash to put to work.
What would make her a buyer? First, Bannan says, the Federal Reserve Board has to take “real action” to show it’s serious about keeping money tight enough to restrain inflation. That means a half-point rise in the Fed’s benchmark short-term interest rate, from 3.75% to 4.25%, she says--a move she hopes to see next week.
Second, “I need to see signs that the economy isn’t that strong,” Bannan says. A month or two of mostly moderate economic reports could convince her, she allows.
There’s a chance that neither of her wishes will be granted, of course. But with small investors and foreigners already moving into bonds, even a minor turn in sentiment by U.S. fund managers could be enough to spark a dramatic rally in this beaten-up market. Rates don’t go up forever--at least not in a straight line. Enough may be enough.
Enough Is Enough?
How yields on some bonds and utility stocks have risen since Feb. 4, when the Federal Reserve Board first tightened credit:
Annualized yield: Investment Feb. 4 Tues. 1-year Treasury bill 3.83% 5.46% Duke Power stock 4.66 5.53 Brooklyn Union Gas stock 5.05 5.90 Southern Co. stock 5.69 6.47 General Pub. Utilities stock 5.86 6.49 3-year Treasury note 4.65 6.54 10-year Treasury note 5.88 7.31 30-year Treasury bond 6.36 7.49 Detroit Edison stock 7.13 8.11
