Best Practices: Why Is the Bond Market Rallying?

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On Friday, bonds rallied in a big way.  The interesting thing is, not even the professionals are sure why.

Before we dive deeper, it’s worth looking at why this question is important.  The bond market is much larger than the equity market and usually, they move in opposite directions.  When investors are concerned, they take money out of stocks and put it into bonds, making the prices of bonds rise.  The interest on an existing bond is fixed, so as bond price rises, the yield on the bond actually falls.  In the opposite situation, when markets are doing well, investors take money out of bonds and put them into stocks.

That’s the usual correlation, and that’s why investors are worried.  Despite the relatively positive employment number, bonds rose, which implies that the market is worried about the economy.  Fact is, bonds have been trending up for some time, so if anything, Friday’s move seemed to confirm the upward trend.  Bond investors are usually longer-term fundamentally-oriented, so many believe that bond investors are usually right in the long-term.  At the very least, stock investors are wondering what bond investors know that equity investors do not.

Is there a rational explanation for this divergence?  A number of explanations were put forth on Friday.

One is that investors were afraid of action by Russia over the weekend.  This has probably been a driver of the recent bond rally.  It is, in fact, a driver that is not likely to go away any time soon.  But, it’s not clear if this the major, or the only reason.

A second explanation is that bond investors were short going into Friday’s employment number.  The idea was, a better-than-expected jobs number would confirm that the economy was on track in its recovery.  This would cause investors to take money out of bonds and put it into stocks, leading to a rally in equities.  When this didn’t happen, the shorts had to cover their short position and buy back bonds, causing a rise in bond prices.  Personally, I do think this was a factor on Friday, but it doesn’t account for the long-term trend.

A third explanation for the recent rise in bond prices is that Fed tapering is actually shrinking the supply of bonds.  The Fed is printing less, so the actual supply of bonds is falling.  This does make sense to me and has likely been a factor.

The last, and most worrisome reason for equity investors, is that the economy is weaker than thought.  This may be, in fact, true.  Thing is, we won’t know for a while and in the meantime, the signals are mixed.  One possibility is that many investors are buying bonds just to be safe – they aren’t sure about the world economy, and they would rather sit in bonds and wait than take risk in equity markets.

Personally, I think all these are true, but that the last is the biggest driver of the recent bond rally.  As I’ve mentioned in previous blogs, many believe that this summer will be weak and that a rally will occur at the end of the year.  That doesn’t give many investors reason to hold stocks over the summer.  Given that Russia, China or Japan could cause worldwide concerns at any time, investors may be thinking about caution more than about potential gains over the next few months.

I am long the TLT.

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