Stock Market Rally Results In More Bond Buying

It is widely expected that the Fed will raise short-term interest rates three times this year. If so, bond yields should go up further in 2018, which should push bond prices lower. In fact, bond yields have already gone up this year, but not as much as most forecasters predicted.

The yield on the 10-Year Treasury Note has only gone up from around 2.4% to just over 2.7% in January as you can see below.

The question on many investors’ minds is, why haven’t bond yields gone up more, especially with the Fed intent on raising interest rates at least three times this year and next?

Here’s one reason why. Stocks have rallied to record high after new record high over the last few years. What many people don’t know is that pension fund managers and institutional investors have strict stock/bond ratios to keep in balance as stock prices keep reaching new record highs.

These ratios of stocks versus bonds vary among pension funds and institutional investors, but the point is they strive to keep those allocations in the same percentages over time. What this means is that as the value of stocks has risen to record high after record high, this requires fund managers to keep adding to their bond allocation in order to keep the percentages in line with their particular ratio.

Let’s put that into perspective. While the S&P 500 Index has returned about 6.2% since the beginning of the year, 10-year Treasury futures have slumped 1.5%.

With those profits and losses in mind, pensions and institutions will need to purchase about $24 billion in fixed-income securities (bonds) just ahead, while selling an unusually high $12 billion of US equities. This is according to Credit Suisse and other big bank asset allocation models, to keep their portfolio mix in line with their stock/bond ratios.

This combination has lent more support to bonds than many would have expected. While that doesn’t necessarily mean that stocks will stop rising, or that bonds will stop falling, it does suggest that both trends may be tempering. It also may explain, at least in part, the latest weakness in stocks this week.

Then There is the Question of Inflation Resurging in 2018

Given the growing consensus among forecasters that the US economy will expand by at least 3% this year, there are rising concerns that inflation could become a problem in the second half of this year if not sooner. If correct, one would expect that bonds should be reacting more negatively already, since long bonds are thought to be most sensitive to higher inflation. But take a look at this longer-term chart on bond yields from Bloomberg.

As you can see, 30-year bond yields have yet to breakout above their long-term downtrend line since 1990. As should be obvious, long-term interest rates cannot continue lower forever, and will certainly rise above the downtrend line at some point in the future. Yet the point is, it hasn’t happened so far.

What this tells me is that it’s not time yet to get overly concerned with rising inflation. That time will come, of course, but the bond market is not signaling that it will necessarily happen this year. We could see another year of inflation generally around 2% in 2018 – as measured by the government’s Consumer Price Index.

Finally, and for the record, I don’t believe that inflation is really growing by only 2% any more than you do. Whenever I make statements like the one just above – that inflation could remain around 2% – I get responses from readers suggesting I don’t know what I’m talking about.

Just keep in mind that I quote the official inflation indexes published by the government such as the Consumer Price Index (CPI), the Producer Price Index (PPI), the Personal Consumption Expenditures Index (PCE), etc.

FYI, I happen to be the chief grocery shopper and cook in my family, which means I’m in the store buying food several times a week. I see how much more prices rise than the government’s official indexes. The government wants us to believe inflation is lower than it really is. That’s another topic for another time.

Bottom line: I wish we had better indicators of inflation.

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