With significant selling coming into the beginning of the year, there didn’t seem to be many market watchers predicting the rally in bonds we’ve seen over the past five months. Indeed, with the Fed plodding along with the taper, and speculation that short-term rates could potentially tighten in 2015, the 10-year’s move from 3 to 2.5% this year was widely unanticipated.
As I discussed in an article here on LearnBonds a few months ago, much of the early year rally in bonds was attributable to a “flight to quality” response to a sudden sell off in stocks. However, as equities have largely recovered, bond yields continue to meander south. Some bond pundits, including Jeff Gundlach, seem to think that we could looking at a significant short squeeze with the potential to push yields even lower.
From a fundamental perspective it may seem counterintuitive that bonds would rally amidst economic and Fed signals that domestically we are finally showing signs of improvement. However, just like stock market movement, bond trading on a near-term basis can be influenced by a number of factors.
And while there’s no concrete way to know who may doing what and why when it comes to the bond market, we can certainly speculate on what’s happening. Here are a few of the factors that could be currently influencing the bond market:
- Short covering
- Supply/demand imbalance
- Foreign buying
Let’s talk about each briefly.
Trader short covering:
At the beginning of the year the prevailing thought was an expectation for bond yields continuing their rise, which likely lead to increasing short interest in bonds (bet that bond prices would drop). Given the backup in that trade, it’s possible that those with profits from last year are locking them in or those that got in late are getting stopped out. When a short position is closed (covered) it creates buying pressure.
General Supply/Demand: Since yield on the 10-year rose precipitously since last year’s Fed taper announcement, it is likely that more income investor buy interest has entered the market. If we refer to Economics 101, if that buy interest outweighs the issuance of new bonds and/or the desire for others to sell their bonds, prices will rise and yields will fall. And though the 10 Year has dropped 50 basis points, it is still 100 basis points off lows seen back in 2012. From that perspective, yields are “high” on a near-term perspective, despite them being “low” from a historical perspective.
There is speculation that the Chinese and Japanese, the two largest foreign holders of Treasury securities have been buying aggressively near-term.
So all told, while superficial logic might dictate otherwise, Treasury rates have been dropping. But tactical investors should be asking themselves if that trend will continue. Might we fall to 2% before we snap back to 3% on the 10-year?
My personal inclination is that last year’s taper announcement marked the end of the 30 year bull bond run, and that near-term buying, following severely oversold conditions earlier in the year, will soon run out of gas. Keep in mind that rates have basically doubled in a short span of time. But while I’m doubtful that the buying binge will continue, and expect we’ll see 3% before 2%, I would also expect ample credit market volatility as the Fed continues to pare back its bond buying and investors assess market prospects.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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