Is 'The Bond Rally Of A Lifetime' Finally Over?

When the Fed started talking about reducing its $85 billion monthly purchases of Treasurys and mortgage-backed securities in May, Treasury bonds started to fall (chart 1) and yields jumped (chart 2).

Although Fed officials have vigorously denied that tapering signals an impending rise in interest rates, investors obviously didn't believe the central bankers.

(chart 1)

Many interest rate forecasters shout that the three-decade-long decline in Treasury bond yields is over, and they may be right—finally. These same pundits have been saying so repeatedly ever since rates started down in 1981.

(chart 2)

As I discussed in my recent book, The Age of Deleveraging, and in many Insights before and since, back in 1981, few agreed with me that serious inflation was unwinding and interest rates would fall. Indeed, the consensus called for rates to remain high or even rise indefinitely.

Yet when 30-year Treasury yields peaked at 15.21% in October of that year, I stated that inflation was on the way out and "we're entering the bond rally of a lifetime." Later, I forecast a drop to a 3% yield. Again, most other forecasters thought I was crazy.

Most investors have a distinct anti-Treasury bond bias, and not just because they fervently believe that serious inflation and leaping yields are inevitable. Stockholders inherently hate them. They say they don't understand Treasury bonds. But their quality has been unquestioned, at least until recently, and their prices rose promptly in 2011 after S&P downgraded them.

Treasurys and the forces that move yields are well-defined—Fed policy and inflation or deflation are among the few important factors.

Stock prices, by contrast, are much more difficult to fathom. They depend on the business cycle, conditions in that particular industry, Congressional legislation, the quality of company management, merger and acquisition possibilities, corporate accounting, company pricing power, new and old product potentials, and myriad other variables.

Stockholders do understand that Treasurys normally rally during weak economic conditions, which are negative for stock prices, so they consider declining Treasury yields to be a bad omen. Brokers also don't want to recommend Treasurys since commissions on them are low, and investors can avoid commissions altogether by buying them directly from the Treasury.

Wall Street denizens also disdain Treasurys, as I learned firsthand while at Merrill Lynch and then White, Weld years ago. Investment bankers didn't want me along on client visits when I was forecasting lower interest rates. They wanted projections of higher rates that would encourage corporate clients to issue bonds immediately, not wait for lower rates and cheaper financing costs. That's what's happening today in anticipation of Fed tightening and higher interest rates—more financing to pay for mergers and acquisitions as well as other needs.

Professional managers of bond funds are a sober bunch who perennially fret about inflation, higher yields, and subsequent losses of principal in their portfolio. But if yields fall, they don't rejoice over bond appreciation but worry about reinvesting their interest coupons and maturing bonds at lower yields.

This disdain for bonds, especially Treasurys, persists despite their vastly superior performance vs. stocks since the early 1980s. Starting then, a 25-year zero-coupon Treasury, rolled into another 25-year annually to maintain the maturity, beat the S&P 500, on a total return basis, by 6.1 times (chart 3), even after the recent substantial bond sell-off.

(chart 3)

This is one of our very favorite charts since we have actually participated in this marvelous Treasury bond rally as forecasters, portfolio managers and investors. And please note that we've never, never, never bought Treasurys for their yield. We couldn't care less what the yield is—as long as it's going down! We want Treasurys for the same reason that most of today's stockholders want equities—appreciation.