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Dow Closes Up 62; Is the Bond Market Rally Over?

By Dan Caplinger – Mar 6, 2014 at 4:31PM

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Bonds have had a stronger 2014 than the Dow, but today's rise in yields points to a possible change in bonds' future.

Thursday featured a solid day for the Dow Jones Industrials (^DJI 0.41%), as the stock market continued to plow higher and the S&P 500 set another new all-time record. Much of the enthusiasm for stocks has come from the perception that the global economy has finally made a lasting recovery from the financial crisis five years ago and from subsequent tremors in Europe, China, and other hotspots across the globe. But with the yield on the 10-year Treasury note (TREASURY: TC10Y) having seen a substantial rise in the past several days, investors are wondering whether the surprising gains in bond prices so far this year have finally come to an end.

Source: National Archives and Records Administration.

A sign of things to come?
In the grand scheme of things, today's rise of about 4 basis points, or 0.04 percentage point, in the 10-year Treasury yield wasn't all that substantial a move. Even at levels just below 2 3/4%, the yield on the 10-year is still well below the 3% mark it hit at the end of 2013.

Yet the big potential catalyst for a move higher in yields will come tomorrow when the Labor Department gives its reading on February's unemployment rate and nonfarm payroll growth. Today's data on jobless claims already supported the thesis for a recovery in jobs, with a drop of 26,000 claims to 323,000 raising hopes that Friday's jobs number will be stronger than January's disappointingly sluggish pace of employment growth. Economists expect payroll gains of about 150,000, setting a relatively low bar for a positive surprise.

More importantly for the intermediate term, most investors now believe that most of the unfavorable economic data we've seen over the past couple of months have been weather-related. If inevitable warmer weather this spring releases what proves to be pent-up demand that consumers didn't satisfy during the cold winter, then the resulting boost in economic growth will confirm the Federal Reserve's course of easing back on its bond-buying activity. That in turn should support the upward movement in the Dow that we've seen since the beginning of February, and higher bond rates will be necessary to compensate bond investors for the returns they're missing out on in the stock market.

Endless supply
From an even longer-term perspective, bond investors are also somewhat worried about the latest trends in Washington. With the new budget proposal from the Obama administration including substantial tax increases without funneling all of the resulting revenue increases toward closing the budget deficit, the government is signaling a potential pullback even from the small efforts that it has made to try to rein in the federal debt's growth. With a debt-ceiling debate now off the table for 2014, bond investors need to prepare for the potential for rising supplies of Treasuries.

Investors in exchange-traded funds that own bonds have started to do exactly that, moving money out of bond ETFs. According to Bloomberg data, investors have moved an average of $7.3 billion out of bond ETFs in the past five days, in contrast to inflows earlier in the year. So far, losses in bond ETFs have been modest, with iShares 20+ Year Treasury ETF (TLT 0.42%) falling just 2.2% since Monday and iShares Barclays TIPS Bond ETF (TIP -0.25%) dropping less than 1%. Still, both of those ETFs suffered big losses in the latter part of 2013, once it became clear that the Fed taper would happen.

On the other hand, geopolitical risk could help Treasuries. Right now, part of what's pushing yields higher is the reduced tension between Russia and Ukraine, reversing the drop in yields that accompanied Russia's aggressive moves in the Black Sea region last weekend.

Unfortunately, there's no certainty whether the bond market's best days are over or not, as pressure to push interest rates higher and bond prices lower could disappear if the economy starts slowing down. For now, though, economic conditions appear to be strengthening, and that could spell trouble for bonds in the coming months and years if it lasts.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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