“Right now bonds should come with a warning label,” says legendary investor Warren Buffett in his latest annual letter to shareholders.
His bearish view on U.S. sovereign debt follows a 30-year bull run and is not shared by everyone. But, as stocks rally to near four-year highs and hopes for a another round of emergency bond-buying by the Federal Reserve recede, more people are asking the same question: has that bull run come to an end?
So far this year, Wall Street’s benchmark S&P 500 index is up 9 per cent. That feisty run, largely on the back of improving U.S. economic figures and confidence that the worst has been avoided in the euro zone debt crisis, compares with a 1.63 per cent fall for long-term Treasuries, bonds with a maturity of greater than 15 years.
Should those moves be sustained, then investors will be looking at a significant break in the long run performance of equities and bonds. In the three decades to 2011, long-term bonds have returned 11.05 per cent annually, according to the Merrill Lynch Master Index, just beating the S&P 500’s return of 10.98 per cent. Both numbers include the reinvestment of bond coupons and dividends.
Indeed, yields on U.S. Treasuries have fallen so low – to less than 1.9 per cent at one point this week – that any rise in the headline annual rate of inflation, currently 2.9 per cent, would only make U.S. government debt, for all its haven characteristics, look even more unattractive on a real return basis.
David Ader, strategist at CRT Capital, says: “The bull market is over given the context that the 10-year yield has fallen from nearly 16 per cent since 1981 and we are now at 2 per cent.”
For Mr. Buffett, it is the lack of protection bonds offer against inflation that makes the case for owning them so dangerous. “Current rates...do not come close to offsetting the purchasing-power risk that investors assume,” he argues.
“It’s not too early to call the end of the bond bull market,” agrees Michael Kastner, principal at Halyard Asset Management. “With negative real returns, it makes no sense to hold Treasuries and the fear trade can only be maintained for so long in a situation where the Fed is actively pursuing inflation.”
Yet, while the bull run for Treasuries may now be flagging, the case for a bear market is harder to make given the still uncertain prospects for U.S. recovery. While higher oil prices could stoke short-term inflationary pressure, they are also likely to act as brake on longer-term growth and leave the U.S. vulnerable to any renewed stress in the euro zone, which could suffer a mild recession this year.
The downside risks lead some investors to believe that the yield on the benchmark 10-year note, which moves inversely to prices and traded on Thursday at 2.04 per cent, could yet fall to a record low. Jim Evans, senior vice-president at Brown Brothers Harriman says: “We are still biased to go lower in rates and I don’t see a bear market looming at all.”
“We still anticipate that the yield on the 10-year Treasury notes will dip to 1.5 per cent before heading back up to 2.5 per cent,” says Steven Ricchuito, economist at Mizuho Securities.
Even those who are bearish on bonds concede that, amid the economic uncertainty, there may still be some short-term gains left in Treasuries.
“Anyone buying a 10-year Treasury has to believe that interest rates will drop, and if you’re a trader or a one-year holder, it may offer some upside depending on the scenario for the economy,” says Jack Ablin, chief investment officer at Harris Private Bank. “The longer you hold a 10-year the worse it looks, as deficits are likely to weigh on the market within the next three to five years,” he warns.
For the last three months the yield on 10-year notes has stayed around the 2 per cent level, held in check by the Fed’s Operation Twist and the potential of more “quantitative easing” should the economy falter in the coming months.
Notwithstanding this week’s disappointment among some investors that Ben Bernanke, Fed chairman, failed to drop hints of more quantitative easing to come, the lingering possibility of further monetary easing is likely to keep a bear market in bonds at bay. “Rates could scrape along at a low level for a long time,” says Mr Ader. “For the foreseeable future we have the Fed controlling the market.”
Indeed, the Fed’s huge presence as a buyer in the Treasury market under the “Twist” program is serving to keep yields at very low levels. That, in turn, makes equities attractive. Not until the economy is on a sounder footing and the Fed signals QE3 is not needed will bonds start looking vulnerable.
Judging that moment correctly will be important. Mr Kastner, who likes equities and thinks the economy is on the mend, believes a bond bear market is closer than many think. “At some point the trading community will hit the bond market. The Fed is playing a dangerous game as they are completely underestimating just how much traders could push interest rates higher.”