Things are looking up for bonds after they were unceremoniously “trashed” during 2013. Such a healthy bond market was unthinkable a month or so ago but here we are - and the implications for the "real" US economy and commodity and equity prices are significant.
As recently as early January the bond market had few friends. Yields were rising back to their northern-summer highs, and many were benefiting as they had in May and June of 2013 as short positions brought in large cash returns. Rates looked as though were “sure” to rise as the burgeoning optimism of 2013, as expressed in US equity market pricing, seemed to have no end. The catch phrase was “rates are going up … right?”
Then came the long-term refunding, where the US government sells long-term debt to financial market participants. Such supply of debt usually tests the resolve of market players, so yields normally rise through the week of the refunding as the longer-maturity bonds are sold later in the week. However, the market held in and stayed resilient all week as US payroll data loomed.
Such resilience spoke volumes about the position of the market, which seemed positioned for rates to skyrocket. Markets were in an unusually optimistic mood and had positioned for further rate increases, with recent data - as measured by the Citigroup economic surprise index - indicating an unusually long period of better-than-expected economic releases.
The problem was that all the good news was in the price. Then came US non-farm payroll data which firmly placed a question mark over things. This data really began to change sentiment in the bond market. If rate rises were not "in the bag", then rates at 3 per cent began to look cheap. So the rally towards 2.75 per cent began as those positioned for higher rates lost money and began to face up to the reality of ongoing stability in rates.
Bond buyers were notching up gains for the first time in months but what was really needed for further strength in the bond market was another shock to global growth. This did not take long to materialise. China rocked markets with a weaker outlook, indicating developed markets wouldn't be "saved" by rampant Chinese growth. These revelations led bonds to trade at lower yields than when the dreaded "taper" by the Fed began.
Now, the market is attributing all the bad data to weather, while all the good news is based on solid growth. No one will admit expectations have really been stretched and a reality check has hit.
Bonds have already come a very long way in a short period of time. The implications of this much more composed market in bonds are important.
Firstly, lower rate expectations, as now reflected in the bond market, will begin to weaken US dollar demand from traders who think another 1994 is just around the corner. In turn, commodity prices should firm as commodities are priced in what should become a weaker US dollar.
Secondly, lower bond rates mean lower mortgage rates and - if these can be sustained - then the slowdown in US housing (forced by higher rates) will recede. Hence, what is good for bonds is also good for the "real” economy, with a lag.
Thirdly, since lower growth is implied by lower-rate expectations, the long awaited correction in equity markets should develop more over 2014.
Most of the damage done in the bond market in the final two months of last year has been undone in January, and we still are yet to finish the month. So the bond buyers may well wear the diamonds this year.
Dr. Stephen Nash is an author and Cambridge Ph.D. graduate with extensive experience in fixed income markets.