Over the past year the stock market has increased over 30% after dividends, while the bond market has seen its first annual decline in 20 years. This gives some credence to the great rotation talk of last year: rising interest rates will prompt outflows from bonds and into the stocks. The Federal Reserve has started to taper back its $85bln a month program by $10bln a month until completed (economic data permitting) which should add to the rise in yields on the long end of the curve. However the path to higher yields will not be one of a straight line, in fact the continuation of the factors above in conjunction with the global economic headwinds could bring about a rally in the bond market this year. There are many unknown factors that can cause a reversal in bonds, but two of the known factors that could have the largest effects on the price on US bond would be global economic factors and Fed policy.
The Fed is expected to continue to taper while putting emphasis on short term interest rates remaining low. This will steepen the yield curve while still providing cheap shorter term lending. This process will put the yields on 5 to 10 year bonds in competitions with the returns in the equity markets. In fact, many pension funds and other liability driven investors will be looking for the safest way to generate their required yields to meet future obligations (usually between 4 to 7%) making a rise in yields generate more demand.
Internationally, the demand for safe haven assets could make the higher yielding bonds of the US more attractive should a crisis occur. Two areas of concern for this year would be Japan and Europe. Japan has had economic success through its fiscal and monetary stimulus programs designed to create inflation and growth. While the stimulative moves have started to show signs of creating inflation, the wages of workers has struggled to keep up, making it more difficult for economic growth to come out of the measures. To add to the headwinds, the government is looking to increase taxes to help manage the enormous debt load of the country which would curb spending further.
Europe is also experiencing a rising stock market and lower borrowing costs across the troubled periphery. The headwinds that could cause a downturn in the euro zone would be the plague of disinflation. Last week the European Central Bank (ECB) has voiced their concerns about the lowering inflation rate in the region, as a lower inflation rate (or outright deflation) makes the debt payments due in the future harder to manage. If this trend continues the ECB is planning to intervene in the markets using some combination of tools it has to stem the decline in the inflation rate.
These issues in both Europe and Japan could spark flights to safety as the countries respective central banks deal with the issues. The main way that they will try to rectify the issues would be with an increase in liquidity into the markets via a purchase program. Combine this dilutive measure with the now higher yields and you can see more demand from overseas investors in the US as a way to make gains on a higher yield and strengthening dollar.
While over the long term yields in the US bond market will go higher, global economic factors and the Feds concern about tightening too soon on the US economy will keep the increase in yields measured and provide opportunities along the way for investors looking to stay diversified.