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Globe Investor Rising yields on U.S. Treasuries may bode well for stock market

U.S. Federal Reserve Chairman Ben Bernanke delivers remarks about a significant shift in the direction of U.S. monetary policy at the Federal Reserve in Washington September 13, 2012.

JONATHAN ERNST/REUTERS

The Federal Reserve's decision to loosen monetary policy has been an elixir for all that ails financial markets, with a notable exception: long-term U.S. government Treasury bonds.

They've cratered. In fact, they'd been in a retreat since early September, falling in tandem with speculation the Fed would announce another round of quantitative easing, its unconventional monetary policy that amounts to the first step in money printing.

The Fed delivered, and the downdraft in bonds turned into a rout, with a big tumble on Friday. Bond yields move inversely to prices and they tell the story. Yields were at 2.68 per cent on the 30-year Treasuries when trading began in September. They punched through the psychologically important 3 per cent barrier on Friday, trading at 3.09 per cent.

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The trend was similar for the bellwether 10-year bond, whose yield rose above 1.80 per cent after being below 1.40 per cent earlier in the summer.

Given the importance of interest rate hikes markets will be watching this week to see whether the carnage continues, or whether things settle back down.

The rise in yields, at first glance, may seem paradoxical. After all, the Fed is printing money again, which should cause yields to fall by increasing the supply of cash to the economy.

But the Fed Reserve's power over rates is greatest at the short end of the yield curve.

"Central bank policy is very, very good at containing yields in the front end of the yield curve, but what it's not very good at is containing yields at the back end," says Ian Pollick, fixed income strategist at RBC Dominion Securities.

Mr. Pollick says some players in the capital markets are worried that the Fed's new program of mortgage-backed-security buying may stoke inflation. The program doesn't have a firm upper limit on the dollar value of securities to be purchased and isn't being "sterilized," or accompanied by offsetting transactions to drain some of the newly created money from the financial system.

Traders are also on alert over the U.S. deficit situation, with questions over whether Congress will act to reduce the severity of the so-called fiscal cliff, market shorthand for the series of automatic spending reductions and tax increases scheduled for the United States at the end of the year. A failure by the U.S. to make much progress trimming the deficit may also weigh on bonds.

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"In a world that's obsessed with debts and deficits, I think the long end deserves to be much steeper," Mr. Pollick said, referring to long-term yields being substantially higher than on shorter maturities.

One reason to expect that long-term rates will rise further is what happened during the Fed's previous two rounds of security purchases. In both cases, rates rose by nearly a full percentage point for both the 10-year and 30-year Treasuries. If past is prologue, yields could go substantially higher even as the Fed is printing money in an effort to keep rates low.

If bondholders believe the Fed's actions are inflationary, or may even work to stimulate the economy, there is little doubt they'll dump fixed income securities, driving interest rates higher and overwhelming the impact of the central bank's purchases. While a downdraft in prices at the long end of the bond market is a bad thing for those holding fixed-income securities, it may hold a silver lining for stock investors.

PiperJaffray & Co. technical analyst Craig Johnson has been watching the 1.80 per cent yield for the 10-year bond for clues about the stock market. He suggests that the shift to higher rates should be taken as a sign to load up on equities. The money fleeing the bond market has to go someplace, after all.

The yield action "may be the cue that a rotation out of fixed income and back into equities" is occurring now that the rally in equities "has shifted into high gear," he told clients in a recent note.

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