Peaking Bond Markets: The Reversal of a 30 Year Trend

Is the three decade long bull market in bonds over?  It certainly seems that way.  Bonds have been retreating across-the-board since early November.  QE 2, which was supposed to bring rates down, simply isn't enough -- even in the targeted middle range of the yield curve.

So what happened in early November?  I don't know. Maybe it was the announcement of QE 2.  Look at Vanguards Total Market ETF: BND.




Consider:

• Treasuries are in an downtrend across the spectrum:  See the 2 year here, the 5 year here, the 10 year here, and the 30 year here.  All show declines after early November peaks. The benchmark 10 year in particular shows an alarming drop.
• Municipals suddenly collapsed  and show no sign of recovery.  PCK, a leveraged California Closed End Municipal fund is down almost 20% since November 7.
• Corporates (LQD) mirror the declines.  Surprisingly, junk bonds (JNK) have held up somewhat better.
• Emerging Markets (EMB) are not immune.

Pundits have long touted the debasement of the U.S. dollar but now the unease is spreading.   Perhaps last month's precipitous drop in munis was a wake-up call.  It will take a lot to change the public's view of bonds as a "safe" investment, but that may now be starting.

The Fed seems to be losing control.  Former Fed Reserve Chairman Alan Greenspan warns that on going deficits will lead to a bond crisis.   Mr Bernanke is between a rock and a hard place.  Tightening may crash markets.  But . . . QE contributes to the perception (reality?) of dollar debasement -- driving interest rates up anyway.  To make matters worse, QE's newly printed dollars flee U.S. shores, contributing to overseas inflation which may precipitate currency wars.

All fixed income instruments will follow treasuries down if rates rise.  You may find a possible haven in convertible bonds.  Blue-chip, dividend paying, stocks may be your best bet for a "safe" investment from here on out. Do your own due diligence.

The bond market is huge ($91 trillion worldwide) -- more than twice the size of equity markets.  If prices continue to decline, some this money will flow into equities and commodities, pushing up inflation.  Commodities are arguably in a bubble while blue-chips are probably not (yet).  Once inflation gets started, it is very difficult to stop. You can argue over what is inflation but precise definitions of inflation are meaningless to most people.  If the price of fuel goes up . . . it is inflation to them -- even if wages are stagnant or falling.

Keep an eye on the Fed.  It seems QE is needed on a ongoing basis to prop up the economy.  At the slightest sign of tightening (such as the pending expiration of the Build America Bond program) markets head south fast.  Bernanke says he is not going to allow deflation, yet the Fed has to pump harder and harder just to stay even.

The ground world economies are standing on is getting steadily narrower, sooner or later we will fall either into the pit of deflation or the excesses of inflation.  Either way it won't be fun.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours