Bond rates rise, and the world doesn’t end
THE great mysteries of the ages:
What killed the dinosaurs?
Did aliens help build the pyramids?
And why were investors willing to accept such low yields on long-term bonds in recent years?
The sudden end of that gracious acceptance of paltry returns has been Topic A in financial markets worldwide in the last few weeks. The annualized yield on the 10-year U.S. Treasury note, a benchmark for mortgage and other long-term rates, surged to a five-year high of 5.3% on Tuesday before falling back by week’s end to finish Friday at 5.16%.
The bond market’s conniption has been a global affair. Europe, Japan, Canada, Australia, India -- almost anywhere you look, yields are up sharply this spring, and particularly just since May.
This trend had all the earmarks of a financial market calamity because everybody knows that rising interest rates are bad news.
Or maybe not so bad. Stock markets around the planet hiccuped in the first week of this month as rates continued to climb. But last week, stock bulls couldn’t stay away any longer. The Dow Jones industrial average ended the week at 13,639.48, a mere 0.3% below its record high reached on June 4. Many foreign markets finished at record or multiyear highs.
Stock investors may be irrational from time to time, but in this instance there may be a good reason they aren’t terribly flustered by higher interest rates: They’ve figured for quite a while that rates, specifically long-term bond yields, were bound to rise with an expanding global economy.
Bond yields were so low from 2003 through 2005 that the phenomenon was dubbed a “conundrum” by former Federal Reserve Chairman Alan Greenspan.
One theory routinely put forth was that a global savings glut was depressing yields. This view held that so much money was looking for a home that investors worldwide were falling over themselves to buy bonds. That meant bond issuers could get away with paying yields that seemed ridiculously low in the context of returns on other investments.
The glut concept could never be proved, but it sounded more polite than another theory: that bond buyers had a case of temporary insanity.
Whatever reason investors had for accepting low yields, they’re no longer so accommodating. To which world stock markets appear to be saying, “Welcome back to reality.”
Rising bonds yields “are a shock, but in actuality we’re just going back to the way things should be,” said George Goncalves, a Treasury-bond strategist at Morgan Stanley in New York.
But why now? It may finally be sinking in that the global economy isn’t about to roll over.
“I think you’re seeing a move up in rates driven primarily by strong global growth,” said Vadim Zlotnikov, chief equity strategist at investment research firm Sanford C. Bernstein & Co. in New York.
Bond investors are taking another look at what’s a fair yield to earn on long-term securities given the world economy’s strength, the upward trend in short-term rates (courtesy of central banks), inflation risks and competition from other investments including stocks.
The good news for individual investors who want to lock in a fixed return is that you’re being paid much more to do so than, say, a few months ago.
At 5.16% on Friday, the 10-year U.S. T-note yield was up 0.67 of a point from early March, when it was 4.49%.
Is that high enough to make it worthwhile?
When the T-note yield reached a five-year high of 5.3% on Tuesday, “You hit levels where a lot of real investors decided to put money to work,” said Brian Edmonds, interest-rate chief at bond dealer Cantor Fitzgerald in New York.
But many analysts still are leery. They note that investors can earn 4.7% or better in short-term money market mutual funds.
Assuming the global economy doesn’t slow significantly, bond investors now seem like they’re in a mood to continue demanding higher yields, said Goncalves. That means it may be smarter to wait to lock in, he said.
“We’re definitely in the camp that it’s still a higher-rate environment,” he said.
Treasuries aren’t the only fixed-income investment, however. Some investors may find that yields on other bonds are compelling enough to warrant a serious look.
California this week will sell $2.5 billion in tax-free general obligation bonds, in various maturities. On Friday, five-year state bonds were yielding an annualized 4.1%, the most since 2001. For someone in the combined 34.7% federal and state marginal tax bracket, that’s the same as earning 6.3% on a taxable bond.
The message from global stock markets, meanwhile, is that rising bond yields aren’t yet a problem.
The pullback in stock prices earlier this month, in part because of the surge in yields, didn’t amount to much. The Dow fell 3% from June 4 to June 7. The German market lost about 5% that week. Brazil’s hot market barely paused for breath. By late last week it was back to the races for those stock markets and many others.
The most telling trend may be in long-suffering Japan. The Nikkei 225 stock index is up 7.8% since March 14. In the same period the yield on 10-year Japanese government bonds has jumped from 1.57% to 1.94%.
In Japan, higher interest rates clearly are a sign of good things in the economy.
Historically, it hasn’t been unusual for stocks to advance even as interest rates rise, if a strong economy is what’s driving rates up. That same economic strength also ought to boost corporate earnings underpinning stocks.
Michael Darda, chief economist at investment firm MKM Partners in Greenwich, Conn., has been bullish on the global economy and on stocks for the last year, even as many analysts have advised cautione. Darda says he still believes the economic picture presents “an incredibly bullish backdrop for equity prices.” He’s predicting a 14% jump in the Standard & Poor’s 500 index in the second half of this year.
Investors, he says, want to go with growth, and the rise in bond yields this year isn’t enough to damp the economic outlook.
There are, of course, still plenty of people who are more cautious than Darda.
Michael Vogelzang, chief investment officer at Boston Advisors, worries that the jump in interest rates will be enough to begin choking off corporate takeover activity. That would damage a key pillar holding the stock market up, he said.
He thinks there’s a strong chance of a 10% pullback in major U.S. stock indexes this summer, stoked by higher interest rates.
Even so, Vogelzang said, any market decline would be a good opportunity for investors to buy into stocks of companies that are riding the global economic boom -- particularly in sectors such as heavy industry and energy.
In the developing world, he said, “Nothing in the long run is going to knock off the trend from bicycles to mopeds to cars.”
