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 The benchmark Standard & Poor's 500 set multiple records in the last
few weeks, while the Barclays U.S. Aggregate Bond Index <.BCUSA> is
up 3.3 percent this year, having also hit a record. However, the
rally in yields that brought the benchmark 10-year bond to its
lowest level in nearly a year last week has some investors saying it
may be the bond market that's gone too far.
"It's a bit head-scratching," said Bob Doll, chief equity strategist
at Nuveen Asset Management with $120 billion in assets under
management. "To me there are signs everywhere the economy is about
to get better, and we won't know it until we get second-quarter GDP.
Inflation is not going to be high but unlikely to be as low at the
end of the year as it was at the start of the year.
"When these other things fade away, my view is we could get a quick
move up in rates."
Signs that investors are starting to cotton to this are emerging.
Stronger-than-expected U.S. economic data, including on recent
inflation, has stemmed some of the enthusiasm for Treasuries. The
10-year yield hit 2.60 percent on Wednesday, highest since mid-May.
And some strategists say the bond market has been unnaturally
bolstered by sinking yields in key bond markets in Europe, where the
central bank is still ramping up monetary stimulus, as well as by
buyers such as pension funds seeking to lock in 2013's equity gains.
In Asia, Chinese growth is slowing, while Japan is easing its
monetary policy.
CUTTING OFF THE RALLY
Since the 2007-2009 recession, the Federal Reserve has effectively
printed about $3 trillion. It has kept interest rates near zero for
more than five years, and new Fed chair Janet Yellen said the U.S.
central bank will keep them there for a considerable time even after
it ends its bond-buying program.
"We are in a period of low economic growth with little inflation and
that's good for fixed income markets," said Gary Pollack, head of
fixed income trading at Deutsche Bank Private Banking in New York.
"It's also good for equities because they don't have to worry about
the Fed raising rates any time soon."
However, the Fed is reducing monthly bond buying, and the April-May
bond-market rally that saw the 10-year drop nearly 0.40 percentage
point raised concern that the Fed's reduced support would hurt
economic growth.
Other outside forces are at least partially responsible for the bond
market's rally, investors said.
The European Central Bank is on the verge of introducing more
stimulus that has driven down yields on Europe. Investors seeing
10-year rates below 3 percent in economies such as Spain and Italy
have instead shifted to the U.S.
"What bonds are telling us is that the typical U.S. cyclical
framework for analyzing rates is no longer valid," said Krishna
Memani, chief investment officer at OppenheimerFunds in New York,
which has about $245 billion under management. "Outside forces
should continue to depress U.S. rates even as the U.S. economy and
corporate earnings growth gather momentum."
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VALUATIONS FAVOR STOCKS
Rather than see U.S. yields go lower, big investors expect that
healthier U.S. economic data will slow the rally in bonds while
stocks won't suffer a catastrophic tumble.
The S&P 500 <.SPX> is on track for another record year. In the last
five years, the U.S. stock market has seen its longest rise without
experiencing a decline of more than 10 percent. That's been a
concern - but some worrisome areas of the market including Internet
retailers and biotechnology have sold off dramatically since the
beginning of the year.
These market gains have pushed the S&P 500's valuation toward the
upper end of its historical range. The S&P 500's 12-month forward
price-earnings ratio is currently 15.4, about on par with the
average since 2000, but bonds - both government and corporate - are
way richer.
The gap between the U.S. 10-year and the S&P 500 earnings yield
(computed by dividing estimated S&P earnings by the price of the
S&P) has widened to about 3.90 percentage points, compared with
about 3.50 at the start of the year. The 10-year is at about 2.60,
and the S&P's earnings yield is around 6.48 percent.
That's an enormous gulf - the long-term mean is about 1.43
percentage points - and it shows how investors are not being
compensated for the risk in bonds.
"At current levels, traditional bonds in particular offer little
value," said Russ Koesterich, chief investment strategist at
BlackRock in New York, which has about $4.3 trillion under
management. "We don't expect a big selloff in bonds, causing rates
to sharply climb back up, but overall, we continue to favor equities
over bonds, even as stocks continue to move toward new highs."
(Additonal reporting by Jennifer Ablan. Editing by David Gaffen and
John Pickering)
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