What Investors’ Love Affair with Bonds Means for Stocks

Dear Wall Street Insights & Indictments Reader,

It’s all good in the Three Bears’ house (bonds, stocks, and commodities), at least according to Goldilocks.

That’s because what’s “just right” is the bond market.

The highflying bond market pushes stocks higher and keeps commodities from being too hot or too cold.

But the bond market can’t carry the weight of the world forever.

Eventually, or suddenly, yields will start rising, maybe from inflation, maybe from central banks “normalizing” yield curves, or maybe frighteningly quickly from bond vigilantes selling them down.

And when rates rise, stocks are going to take the brunt of the bloodletting.

Here’s why bonds have been hot, why they’re cooling down, and what will happen to stocks when investors’ love affair with bonds ends…

Hot Porridge

Bonds are hot. They’ve been hot.

Obviously, that’s because central banks keep pushing rates down.

As yields fall on existing bonds, their prices rise. The Fed and other central bankers, through their various schemes, have driven down rates and driven up bond prices for years.

That’s made bonds a good trading vehicle for big players.

With rates on the shortest end of the yield curve so low, or negative, traders can borrow cheaply to finance the purchase of longer-dated bonds. That’s called a carry trade, where the “carry,” or cost of financing a position, makes the trade work, even if the purchased bonds only move up a little.

Speaking of negative rates, the world’s now awash in over $10 trillion worth of negative yielding government bonds.

If you’re wondering, who on earth would buy negative yielding bonds? – the answer is big institutional bond players, banks’ trading desks, and hedge funds.

With the cost of carrying positions so low, traders buy bonds, even though they don’t provide any yield, which means, in effect, they are paying the government for the privilege of warehousing their debt.

The reason these negative yielding bonds are bought is for price appreciation. It’s a trade.

As long as central banks keep leaning on rates, lowering them even slightly, their prices rise. Traders with leveraged positions are looking for capital appreciation (price increases) on their trades, not yield.

The rally in bond prices, which drove down yields for investors seeking fixed income returns, forced investors into stocks for their better dividend yields and more importantly for the capital appreciation investors expect when more and more money comes out of bonds and goes into stocks.

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The bond market rally’s been working beautifully for stocks.

But, eventually, yields will rise and the house that central bankers built will fall in on bond investors and far more so on stocks.

The market watchers at Bloomberg are worried about it and said so, last week in an article titled, “Hidden Bond Market Dangers Expose Traders to $2 Trillion Wipeout“.

The $2 trillion comes from a calculation of “duration,” or the average maturity of the $52 trillion worth of global investment-grade (government) debt outstanding, and what a rise in interest rates would do on the average.

As of last week, the average maturity of that outstanding debt is seven years, a record long average duration. Longer duration (maturity) bonds are more impacted by interest rate movements.

Just a 50-basis point move up in interest rates, half of a percentage point, would result in a 3.5% hit to bonds with an average maturity of seven years. Based on the $52 trillion outstanding, that would be about $1.8 trillion in loss.

That’s where Bloomberg gets the $2 trillion number.

We saw what a couple of small interest rate hikes did to stocks last year from October to December.

It got so ugly so quickly the Fed and other central banks around the world had to jump back in and push rates and “forward guidance” down in a hurry.

That’s what stocks have to look forward to. I mean, what they face in terms of bloodletting.

It’s going to happen. We know that, because it just happened.

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So, enjoy the “Goldilocks” everything now.

One day, and it will be sooner rather than later, the bears are coming home.

And we’ll be ready to meet them when they do. On Thursday, April 18, at 1 p.m. (ET), I’m pulling back the curtain and revealing my unorthodox trading strategy, one that’s made me a millionaire, several times over.

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Sincerely,


Shah

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