WHY BOND YIELDS HAVE STAYED SO LOW FOR SO LONG -- AND WHY THEY SHOULD START RISING -- RISING RATES AND OIL COULD CAUSE MARKET PROBLEMS IN THE NEW YEAR
RATES SHOULD BE MOVING HIGHER... This time last year I wrote about my expectation for long-term interest rates to start moving higher during 2004. I got it only half right. They moved higher during the first half, but then fell back during the second half. It looks like bond yields will end the year pretty much where they started. A number of readers have asked why bond yields have stayed so low for so long and for my outlook for next year. Chart 1 shows bond yields turning back down at the start of 2000 and bottoming in mid-2003. The 2000 peak in yields coincided a falling stock market and rising bond prices. The deflation threat that existed at that time caused a major decoupling of bond and stock prices. As a result, bond yields and stocks became positively correlated. Bond yields turned up shortly after stocks during the first half of 2003, right after the start of the Iraq war and a plunge in oil prices. That caused a major rotation out of bonds and back into stocks -- reversing the 2000-2002 bear market trend. Chart 1 shows the yield on the Ten-year Treasury note turning up during the first half of this year and breaking the four-year down trendline (see circle). That wasn't a surprise. What was a surprise was the subsequent decline in yields back to that same trendline (see arrow). Let's take a closer look.
Chart 1
WEEKLY BARS SHOW HIGHER TREND ... The weekly bars in Chart 2 show that the 10-year T-note yield has been trending higher since the middle of 2003. The eighteen month chart shows that each trough (see arrows) has been higher than the one before. The two peaks also show an ascending pattern (see circles). A pattern of rising peaks and troughs is the most basic definition of an uptrend. Which brings us to the present time. I've drawn a rising trendline under the mid-2003 and early 2004 lows. Yields are testing that trendline now. If yields are going to start rising again, the area around 4% is where that should start to happen (see third arrow). Let's look even closer.
Chart 2
SO DOES DAILY CHART ... The daily bars in Chart 3 show what's happened this year. After a spring burst to the upside to 4.9%, yields fell all the way back to 4%. Some of that decline from May to October was probably due to rotation out of stocks and into bonds. [As stocks were falling, bond prices rose. When bond prices rise, yields fall]. The bounce in bond yields starting in October (first arrow) was probably due to the start of the fourth-quarter stock market rally as money moved out of bonds and back into stocks. [As stocks rise, bond prices fall. That pushes yields higher]. Chart 3 shows that the second half down trendline was broken during November as yields rose to a three-month high. After pulling back to 4.10%, yields appear to be bouncing again. The two ascending arrows show that the second (December) trough in yields is higher than the first (in late October). Again, that's an early sign of a possible uptrend emerging.
Chart 3
COMPARISON OF BONDS, STOCKS, AND OIL... Charts 4 and 5 compare stock and bond "prices" directly. Chart 4 is the 7-10 Year Treasury bond ETF (IEF). It shows the actual direction of bond "prices" (which move in the opposite direction of yields). Chart 5 is the S&P 500. At the start of 2004, bond and stock prices were rallying together. Bond prices started to fall sharply during March (first arrow). That may have contributed to the stock market decline because stocks don't usually respond well to rising rates. Bond prices bottomed in June two months before stocks (second arrow). In both instances (March and June) turns in bond prices accompanied or preceded similar turns in stocks. Which brings us to the present situation. Bond prices peaked in late October as stock prices rose. The December blip in bond prices appears to be failing. That sets a pattern of declining peaks (see circles). It also creates a "negative divergence" between bond and stock prices. And therein lies a warning. Bonds usually turn before stocks. If the bond rally is failing (and rates are starting to rise), that may cause problems for stocks in the new year.
Chart 4
Chart 5
Chart 6
AN OIL WARNING ... Charts 5 and 6 compare oil prices with the S&P during 2004. They've been trending in opposite directions. The uptrend in oil starting in early 2004 contributed to the downside correction in stocks. The October oil peak help launch a fourth quarter rally in stocks (see black arrows). This week crude oil has rebounded sharply from long-term support near $40. [Crude jumped nearly $2 on Friday to move closer to $46]. If the fourth quarter downside correction in oil is over, that could also threaten the corresponding uptrend in stocks.
WHY HAVE RATES STAYED SO LOW SO LONG?... This is a question a lot of us have been asking for months. Here are some possible explanations. The deflationary forces that prevailed until a year ago haven't completely disappeared. Low priced imports from China are preventing American companies from raising their prices. Asian central bankers have been buying U.S. Treasuries to keep the dollar from falling too fast (and to keep their currencies from rising). Since the Fed started raising short-term rates at mid-year, traders have been putting on "yield curve flattening" trades. That means that they sell the short end of the yield curve (T-bills and 2-year T-notes) and buy the long end (10 year T-notes or bonds). Chart 7 shows what that trade would look like. It's a ratio of the 7-10 Year T-Bond ETF divided by the 1-3 Year T-bond ETF. Since mid-year the longer maturity bonds have been rising faster than the shorter maturities. That's because short-term rates have been rising faster than long-term rates. Notice, however, that the ratio appears to forming a "triple top" since October. That suggests that traders may start unwinding that spread. That would push bond prices lower -- and yields higher. Another reason yields may start rising is that the fall in the dollar is driving funds to foreign markets and makes foreign investors demand higher U.S. bond yields. The falling dollar also boosts inflation, which usually results in higher yields.
Chart 7
