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Is a Relief Rally Due for Bonds and Yield Stocks?

Michael Santoli

To sustain a panic, it takes a lot of energy, a constant flow of fear and confusion to power the flight instinct.

In the bond market, the panic that has sent interest rates surging has certainly fed on plenty of worry and has already carried on a long time. The yield on the 10-year Treasury note has shot from 1.63% in early May to a two-year high above 2.90% this week, scaring tens of billions of investor dollars out of bond funds and raising the price of credit across the economy.

10-year Treasury
10-year Treasury

Source: Yahoo Finance

The move from historically low rates to something closer to “normal” levels has been driven by better confidence in U.S. economic growth and the related guidance by the Federal Reserve that it intends, before long, to scale back the pace of its bond-buying stimulus plan from the $85 billion monthly clip it’s employed since September.

Yet a few signs are coalescing to suggest the bond-selling, rate-boosting scare might be tiring. This would allow rates to ease back a bit, which in turn could fuel a nice relief rally in all manner of yield-centric investments that have been ravaged in the bond-market rout, from municipal bonds to real estate investment trusts to junk bonds and perhaps even homebuilder stocks.

Yield curve gap

This isn’t to say Treasury yields will nearly undo their entire surge this year or that they won’t eventually climb above 3% in response to expectations of a less-generous Fed or a pickup in economic growth. But for now, the yield advance has arguably overshot, and the sectors pummeled as a result have suffered from investors planning for a rapid and relentless climb in rates that isn’t likely to happen.

The case for a relief rally in Treasuries (and a corresponding decrease in yields) is built on excessive pessimism already built into the Treasury market, the likelihood that short-term rates controlled by the Fed will stay near zero for a very long time, and the reality that higher yields -- and mortgage and auto-loan rates -- themselves help brake the economy and could make the central bank less aggressive in stepping back from its stimulus.

The entire financial world, it seems, has pivoted toward an expectation that rates will surely keep rising. The Daily Sentiment Index for Treasury bonds showed only 9% were bullish on Treasuries (meaning only 9% were betting on lower yields), according to RBS strategists Friday, a lopsided stance against bonds that’s confirmed by other measures of large investors. Retail investors, as noted, have pulled some $90 billion from fixed-income funds since Memorial Day, says the Investment Company Institute.

With the rush higher in Treasury yields, the gap between short- and long-term government-bond rates, known as the yield curve, is already near an extreme. The two-year Treasury, which is tightly tethered to the Fed-dictated overnight rate, is just below 0.40%.

Yield curve
Yield curve

Source: FactSet

With bonds at 2.90% this week, that gap of 2.5 percentage points is quite wide, exceeded only for rather short periods of time over the last 30 years. (Given that overnight rates have never been zero deep in a U.S. economic recovery phase, it’s possible what used to be an extreme gap is less extraordinary on an absolute basis, but nonetheless should restrain further huge upside in rates.)

Sure, there are some commentators suggesting that the Fed has lost control of longer-term rates as it has hinted at eventually sun-setting its bond-buying. Some even insist the market is expressing its concern that potential Fed chairman nominee Larry Summers will get the job and will seek to thwart financial risk-taking with unduly tight monetary policy.

This is far-fetched, and today’s Fed can easily reassert control by changing its tone back to market-soothing assurances of no “tapering” of bond purchases very soon.

Possible ETF opportunity

The economic data, in fact, have been mixed enough to perhaps elicit some more dovish sentiments from the central bank, perhaps even this weekend at its Jackson Hole conference. Housing activity has cooled in part due to higher mortgage rates, and retailers have been reporting soft sales trend over the summer.

Says Bank of America Merrill Lynch U.S. economist Michael Hanson: “The sizable sell-off in bonds since May appears to have convinced many that the Fed has no choice but to ratify market expectations and taper in September. We disagree, and think it more likely to convince the FOMC to taper later.”

Tom Sowanick, longtime Wall Street bond strategist and now chief investment officer at OmniVest Group, points to a newly devised economic bellwether that is flashing a warning of tepid business activity in the latter part of the year. Billtrust is a leading outsourcer of business-to-business invoicing and now calculates the Billtrust B2B Sales Index.

Sowanick says the index, which dipped 1.3% in July, has a high correlation with nominal GDP growth two quarters ahead and “portends a pronounced weakening of the U.S. economy towards the end of this year.” Sowanick, in the longer term, believes rates will reach higher levels as the economy gains traction. But, tactically, he says “there is scope for long-term Treasury yields to fall from current levels.”

If this plays out, then opportunistic investors might look to exploit it through roughed-up fixed income ETFs, such as iShares Barclays 20+ Year Treasury Bond (TLT), iShares S&P National AMT-Free Muni Bond (MUB), SPDR Barclays High Yield Bond (JNK) or the Vanguard REIT Index (VNQ).

With the 30-year mega-bull market in bonds likely having peaked, these are not buy-them-and-forget them investments. But they could very well work for a trade, assuming the rate-rise panic subsides for a while.

Follow me on Twitter @MichaelSantoli