The Bear Case for Bonds? We've Heard It All Before

(Bloomberg View) -- Besides the never-ending run-up in stocks and the fantastic gyrations of cryptocurrencies, the other big news in markets -- and perhaps the most consequential -- is the rise in bond yields.  

A recent Google search on the topic "end of bond bull market" pulled up 13.3 million articles in less than half a second. A search on "bond bear market" came up with 11.4 million articles. To put those results in context, anything related to a bull market in bonds resulted in about 75 percent fewer references. 

The yield on the benchmark 10-year Treasury note has risen from last year's low of 2.01 percent in early September to as high as 2.63 percent last week. Many media outlets are predicting that yields could soon hit 3 percent, and that even 3.5 percent isn't out of the question before the year is out. Neither is likely to happen.

The bear case generally centers around eight arguments:

• Momentum is working against the market as higher yields beget higher yields.
• The behavior of Treasury Inflation-Protected Securities, or TIPS, on the back of gains in oil, wage hikes and bonuses in response to lower corporate tax rates.
• Speculation that China will be buying less Treasuries going forward as the Trump administration increasingly talks of tariffs and a trade war.
• The Bank of Japan and European Central Bank will soon start to pull back from bond purchase programs, as the Federal Reserve has.  
• U.S. borrowing is about to balloon to finance an expanding budget deficit and pay for the recently enacted tax cuts.  
• The White House's stance on trade and how that might raise import prices -- adding to inflation -- while reducing demand for U.S. assets. 
• At about a negative 45 basis points, or 0.45 percent, the 10-year yield's the term premium -- which is the extra compensation investors demand to bear the risk of lending money for longer periods of time -- is abnormally low and a reversal to more normal levels in positive territory would alone push up yields.
• The softer tone to the dollar amid better global growth, which is provoking tighter monetary policies in most of the Group of 7 economies. 

That's all well and good, and I am also somewhat bearish these days -- just not 3.50 percent bearish. As things stand, the Fed projects the federal funds rate to be about 2 percent by year-end, an increase of 50 basis points to 75 basis points from the current target range. A 3.50 percent 10-year yield would represent an increase of about 90 basis points and a level that implies a steeper yield curve, or a bigger spread between short- and long-term rates.

But that is not how the curve behaves when the Fed is raising rates. Typically, the curve flattens, as has been the case so far in this hiking cycle. Plus, the economic conditions -- inflation -- that would warrant a 3.50 percent yield would demand a much more aggressive Fed than the 2 percent fed funds rate projection currently in place.

None of the eight arguments above are new. Also, the bearish price action that starts a new year is seasonally habitual even in bull markets, but is not necessarily prologue, especially when risk assets -- read stocks -- are also subject to all of the arguments, but they are flying higher. The point is, you can't confidently talk about a 3.5 percent 10-year yield without asking what that means for stocks. Let me cut to the chase: The same accommodative monetary policies that have helped to keep interest rates low are responsible for boosting the values of the stock market. Remove the proverbial punch bowl from the bond market, and you're removing it for equities as well.

That leads us to the issue of relative value. Treasury 10-year yields are about 60 basis points higher than the S&P 500 dividend yield. If 10-year yields were to rise by 100 basis points and the yield on the S&P 500 held steady, the spread would be 160 basis points, in line with the 164 basis-point mean average since 2000 (knowing that 14 basis points is the mean since 2012!).

My point is that higher 10-year yields would look quite attractive to stocks, and if they do get to 3.50 percent by year-end, they would make for a nice holiday gift. I expect yields to get to about 2.85 percent by the middle of the year and hang around that level. I also think that if all the bearish factors mentioned above come to fruition, the risk will be for a more aggressive Fed, which, with history as our guide, would compel me to forecast a flat to inverted yield curve.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

David Ader is chief macro strategist at Informa Financial Intelligence. He was the No. 1 ranked U.S. government bond strategist by Institutional Investor magazine for 10 years.

To contact the author of this story: David Ader at dader2@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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