WHAT HAPPENED TO BONDS

SOMETHING'S GOTTA GIVE!

Since about this time last year, the bond market has suffered what the Wall Street Journal describes as "the worst bond performance for long-dated bonds since 1927". The year-to-date total return of the thirty-year Treasury bond is a negative 12%. Throughout much of last year’s fourth quarter, Treasury bonds were the world's favored investment vehicle. Long term Treasuries yielded as low as 4.7% during early October but are now trading around 6.1%. In that we thought 5.5% was a more reasonable yield for the long Treasury bond, we reduced our average maturity during the first quarter. Clearly we didn't see 6%-plus yields in the offing.

Now it's time for another look into the future. Although inflation reports have been relatively good, the fear of inflation has overpowered this positive news. As the Asian economies began to recover late last year, the economic reports from U.S. manufacturers reflected strengthening demand. This, in turn, put upward pressure on key industrial commodity prices, with copper and oil in the lead (see below). Furthermore, as labor costs began to accelerate, the Federal Reserve decided to raise the Federal funds rate in order to preempt any emerging inflation.

Additional factors causing negative sentiment for the bond market is a weak dollar and significant supply of corporate bond financings. It is quite possible that the weak dollar vs. yen encouraged some Japanese holders of Treasury debt to repatriate their holdings. (A weak dollar has always been considered a negative psychological factor for the bond market.) And investment grade bond financings have been strong during the first 9 months of 1999, partly in response to Y2K liquidity concerns.

Many of the perceived negatives for bonds are already "in the market" however. Sentiment readings for Treasury bonds are unusually pessimistic . . . and this could turn out to be a positive (see below). We have not observed this level of negative sentiment in the last twenty years.

Unless consumer prices ratchet upwards, we expect that this negative sentiment will help stabilize bond yields through year-end. Bond yields might even decline back toward our estimate of their intrinsic value if economic growth begins to falter. Already we are seeing signs of weakness in some sectors. Mortgage applications for home refinancing have declined dramatically from year-end levels and this is now impacting retail sales. The key, however, is when dampened marginal demand finally affects the manufacturing sector. Although export demand and inventory filling have been keeping manufacturers busy, there are some signs that higher interest rates are beginning to brake the economy.

The earliest warning signs of changes in manufacturing momentum is provided by the National Association of Purchasing Managers (NAPM). In its most recent release, the NAPM reported that new order and export order trends were no longer accelerating, as they had been during the first half of the year. These two components tend to lead the overall index. The following chart illustrates the fluctuations of the NAPM index how this leading indicator has impacted bond yields.

Our best estimate is that there is a 30% chance that bond yields could rise to 6.4% by year-end but a 60% chance that they will remain in the 5.8% to 6.1% band. And yes, there is a 10% chance that yields could drop to 5.5% within the same timeframe. Much of the upcoming action will depend on the next NAPM report. More importantly, we believe that bond market sentiment will be dictated by stock market direction. (The contrary is also true!) If the stealth bear market that has been taking the non-blue chip stocks down spreads to the Favorite Fifty, Chairman Greenspan will be much appeased, as will be the bond market. If stock indexes remain strong, then the recovery in bonds will be delayed. To borrow the title of an old Johnny Mercer tune, "something’s gotta give"!

--John K. Dolan

September 24, 1999
Treasury Bond (30 Yr.): 6.04%
S & P 500: 1280

URL this page: http://www.dolancap.com/research/something.html