U.S. long bonds: Buyer beware!

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Bill Gross is buying them after misreading the market last year, while the Fed is buying them in their operation TWIST. The bull run is supported by the perceived safe-haven qualities of U.S. bonds, especially in the current weak patch in global growth and the crisis in Europe that is culminating in the degrading of sovereign bonds. The stronger U.S. dollar is also an added attraction. On the other hand, Warren Buffett and some prominent commentators, this blog included, have been warning against the bubble in U.S. bonds since 2009. Yes, we nay-sayers have missed an incredible bull market in U.S. bonds over the past 18 months. Have we been wrong about the underlying fundamental value of U.S. long bonds?

Well, the yield on the 10-year government note is nearly 2% below the CPI inflation rate and recently dropped below the core inflation rate for the first time in 32 years.

Sources: FRED; I-Net Bridge; Plexus Holdings.

The circumstances 32 years ago were vastly different compared to today, though. At that stage the core CPI inflation rate was more than 13% while the yield on the 10-year note ranged around 12%. You had the prospect of solid returns if the inflation rate returned to the pre-oil crisis levels.

This time around bonds are pricing in an extended period of deflationary depression. The extent to which the valuation of U.S. bonds is out of sync with the U.S. economy is best illustrated in the graph below in which the yield on the 10-year government note is depicted against the Conference Board Consumer Confidence Index. The relationship indicates that U.S. bonds are priced for consumer confidence falling to approximately 10. That compares to the worst level ever of 25 in the first quarter of 2009 amid the great 2008/2009 crisis.

In normal circumstances the yield on the 10-year note would be closer to 3% or 100 basis points higher than currently.

The U.S. economy is slowly but steadily turning for the better. The improved employment situation supported by rising unit labor costs is pushing the core inflation rate higher.

Sources: FRED; I-Net Bridge; Plexus Holdings.

Holders of U.S. long bonds are therefore faced with a conundrum. If the core inflation rate continues to rise while the yields on the long bonds remain unchanged due to the Fed’s actions, the gap between long bond rates and the core inflation rate will open up even more. Long bonds will therefore become even more expensive. When will this period of irrational exuberance end?

At their most recent meeting, most members of the Fed’s policy-making committee agreed that slow growth was not reason enough to expand the Fed’s economic aid program. With incoming positive economic data the chances of QE3 in the next few months are diminishing fast. Where will the demand for longer-dated bonds come from if the Fed stops buying?

Amid the current rather lethargic growth in the U.S. economy there are clear signs that investors are already increasing the risk assets in their funds. Against the background of negative real returns of U.S. longer-dated bonds any sustainable acceleration in economic growth is likely to switch away from bonds.

However, in the short term bonds are likely to benefit from lower CPI inflation rates as my leading indicator, the absolute change in oil prices from a year ago, is pointing to the U.S. CPI ex shelter declining to between 2 and 2.5% in February/March.

Sources: FRED; I-Net Bridge; Plexus Holdings.

In my opinion, it is therefore not a question of if the bond bubble will burst, but when!

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Equities to outperform in a volatile world

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In its latest Daily Insights report, BCA Research emphasizes that the tail risks facing the global economy and financial markets will hang over markets in 2012, making it another difficult year for investors.

“While monetary policy will remain extremely easy, low rates by themselves do not guarantee that risk assets will perform well, especially since profit margins are extremely high (i.e. the risk is to the downside). But at least valuation is reasonably attractive, said the report.

“Over the medium-to-long term, the total return on global equities should easily surpass [government] bonds, even factoring in very weak growth. For example, if we assume extremely pessimistic nominal earnings growth of 3% over the coming decade and a compression in the price-earnings ratio to 10, equities would still deliver returns above current bond yields. A more reasonable expectation for global equity returns would be something between 7% and 8% a year. For the U.S., equity returns should be around 6%, reflecting lower earnings growth and a lower dividend yield.”

In short, equities should outperform government bonds and deliver reasonable returns relative to alternatives over the medium-to-long run.

Source: BCA Research – Daily Insights, January 5, 2012.

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What’s up in the bond market?

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I do not subscribe to the Lowry onDemand service, but receive the occasional short report from them. The paragraph below is of particular interest.

“The trends of the bond market, as well as the stock market, are the direct result of changes in the forces of supply versus demand. A recent review of the fixed-income ETFs on the Lowry onDemand website reveals a large number of issues reflecting significant negative divergences between their price patterns and our exclusive Power Ratings. Negative divergences occur whenever investor demand for a security weakens substantially while the price pattern is still in a relatively positive trend. Since it is difficult for prices to continue to rise in the face of weak investor demand, well-established negative divergences, as shown in the chart below, are typically followed by important price declines,” said the report.

If Lowry is right on this, it implies a flip to risk on, with better economic prospects, and declining bonds and rising equities.

Source: Lowry onDemand, November 22, 2011.

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Bond fund star Gundlach focuses on deflation

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Jeffrey Gundlach, founder of DoubleLine, which has been the best performing bond fund so far this year, tells the FT’s Dan McCrum that deflation is a greater risk than inflation because he believes it would take another crisis to trigger big monetary policy changes. Mr Gundlach says low economic growth is likely to persist and recommends hedging risk assets with long-term Treasury bonds.

Please click here or on the image below to watch the video.

Source: Financial Times, October 4, 2011.

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Blackrock sees opportunity in risky Europe

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Head of fixed income Rick Rieder says Blackrock is dipping its toes into European financial and insurance firms.

Source: CNNMoney, September 19, 2011.

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Faber says S&P won’t surpass 2011 high of 1,370

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Marc Faber, publisher of the Gloom, Boom & Doom Report, appeared on Bloomberg Television’s “Street Smart” with Carol Massar and Matt Miller yesterday. Speaking from Sao Paolo, Brazil, Faber said that the S&P 500 Index won’t surpass the 2011 high of 1,370 this year, and that investors are “better off in equities than bonds”.

Source: Bloomberg, August 23, 2011.

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