DAVID JOY: Bonds under pressure

Stock prices closed at new highs once again last week. The S&P 500 added another 0.4%, increasing its gain for the year to 26.5%. There is little to say about this rally that hasn’t already been said. So the focus here will be on bonds, which are dramatically underperforming as the cost of credit climbs.

The yield on the ten-year Treasury note has been rising ever since the Federal Reserve met on Oct. 30. Between then and now the yield has increased from 2.50 to 2.74%. The latest move higher came last week after the minutes from that October meeting were released on Wednesday. The market’s reading is that tapering is approaching, maybe as early as December, but more likely in March.

Back in early September, when the betting was that tapering was imminent, the yield on the ten-year rose as high as 2.99%. It could certainly get there again, although headline inflation was also running a little higher during the summer. The twelve month rise in the consumer price index in July was 2.0%, and in August it was 1.5%. With the slowdown in the CPI in October to a 1.0% year-over-year rate, the real after-inflation yield on the ten-year note is the highest in two and a half years, according to Bloomberg. Core inflation, in contrast, has remained steady in the 1.6 -1.8% range for the past seven months.

The Barclays Intermediate Treasury index is down 0.1% this month, and down 0.6% for the year. The long index is down 3.0% for the month, and 11.4% for the year, as thirty-year Treasury bond yields have risen 22 basis points since Oct. 30 and 95 since the start of the year, to 3.85 percent. But, compared to the move between May and September, the recent weakness is modest.

The shorter end of the yield curve has remained anchored in anticipation of the Fed leaving the overnight rate unchanged for an extended time. The two-year Treasury note yield has actually drifted down to 0.28% from 0.31 on Oct. 30.

Much has been made, and rightly so, of the recent shift into domestic equities by mutual fund investors. But money has also been coming out of bond funds. According to the Investment Company Institute, $144 billion has exited bond funds since June, and the pace of outflows has recently accelerated in the past two weeks. The increase in Treasury yields and investor preference for credit exposure in an improving economy has resulted in declining spreads versus lower quality debt. Since Oct. 30, the spread between the ten-year Treasury and the BofA Merrill Lynch High Yield Master II index has tightened 13 basis points to 430, its tightest since May. The Barclays High Yield Corporate bond index is up 0.1% for November so far, and higher by 6.5% on the year.

Although not uniformly robust, the latest round of economic data has contributed to the pressure on bonds, despite the absence of inflationary pressure. The October employment report and recent weekly jobless claims totals suggest ongoing improvement in the labor market. Both ISM indices firmed in October, as did retail sales. So far there is little evidence of much of an impact from the government shutdown. In contrast, one area that has disappointed is housing, which has recently plateaued along with the rise in interest rates. This week’s economic calendar provides a look at activity in October for pending home sales and building permits, as well as home prices and mortgage applications.

Where bond yields are headed remains to be seen. Futures trading suggests a rise to just 3.13% on the ten-year by December 2014, which would mean that most of the expected rise in rates associated with the commencement of tapering took place during the summer, when tapering was expected in September.

Although the likelihood of a December tapering has recently increased, most apply only about a 30% probability of that occurring, with March remaining the most likely timeframe. The November jobs report will influence that thinking. Scheduled for release on Dec. 6, the current consensus estimate anticipates the creation of 185,000 new non-farm jobs. A total in that neighborhood is unlikely to push the FOMC to move on tapering, but anything significantly stronger will increase the odds.

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The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

Barclays Capital U.S. Treasury Bond Index:  Is part of Barclays Capital global family of government bonds indices. The index measures the performance of the US Treasury bond market, using market capitalization weighting and a standard rule based inclusion methodology.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

Barclays Capital U.S. Corporate High Yield Index: Is an unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.

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