Lot of discussion right now about the best way to invest in a rising interest rate environment. While most experts don't think it prudent to sell short bonds, in a five year risk-to-reward basis you want to be exiting treasury bonds and be long on stocks (that also favors commodities and overseas economies that are leveraged to those commodities). But really, the question is how these rising rates will affect the overall economy in a 2011 when equities are expected to be on the rise.
Will Rising Bond Yields Set Back the Stock Market? Thursday, 30 Dec 2010 By: Patti Domm CNBC Executive Editor
While some traders fear rising bond yields could crimp stocks' gains, some bond strategists do not expect interest rates to rise beyond the range of the past year.
"We look at 2011 as a trading, not trending year," said William O'Donnell, who heads rates strategy at RBS. He expects the 10-year yield to stay in a range of 2.75 percent to 4 percent, the top of its 2010 range.
"I know the economy is percolating along. Our economic staff does not think it's sustainable at the pace we've seen in the last couple of months," he said. Some of the worries are a possible, further 7-10 percent decline in housing prices, high unemployment and now, rising gasoline prices, he said.
Higher rates caught the attention of stock traders once more this week, as a thinly traded bond market saw rates ricochet higher and lower, around two Treasury auctions Tuesday and Wednesday.
First, the Treasury's 5-year auction Tuesday suffered from seriously weak demand, kicking off bond selling and triggering a resulting inverse move higher in yields.
Treasury yields then relaxed going into Wednesday, as buyers moved in, and finished the day lower after a strong showing at the Treasury's $29 billion 7-year auction.
The 10-year ended Wednesday with a yield of 3.37 percent, well below Tuesday's 3.48 percent close, and very near where yields began a volatile trading day Tuesday morning. The 10-year yield again edged higher to 3.4 percent Thursday, after a much stronger-than-expected Chicago purchasing managers' report.
Peter Boockvar, equities strategist at Miller Tabak, said aside from this week's action, the recent backup in rates since November is indicative of more to come.
"I think the violence of the move is pretty telling. It's not like this is a small market. It's a multi-trillion dollar market, trading like an internet stock, which is pretty amazing. It tells me there's a definite change here," he said. "The main theme in 2011 is that it's the bond market more than anything that will determine how equities go. There's nothing that can spoil a party in equities more than higher interest rates."
Wells Fargo Advisers chief equities strategist Stuart Freeman, however, does not see rates as an issue for stocks going into next year. "If you move up to 4 percent or even 4.25, perhaps that's something that's going to be more of an issue," he said. He expects the 10-year to be at 3.5 percent at the end of 2011, but he says that level could be surpassed if the economy proves stronger than expected.
In fact, the stock market may benefit as investors reduce bond positions, he said. That rotation is starting to show up in mutual fund flows. ICI reports that equity mutual funds saw inflows of $335 million last week, breaking a 33-week losing streak.
Pimco senior strategist Tony Crescenzi said the success of the 7-year auction was not a surprise, and it is not really indicative of much. "The 7-year was cheap on the yield curve...It doesn't mean the market looked cheap, but that issue was particularly cheap," said Crescenzi. "I wouldn't get crazy happy about the market because of the 7-year because historically, it's always been an ugly duckling."
"It seems like the market is settling in on its new trading range, which for now seems to be 3 to 3.5 percent (10-year yield), and it's trading in the upper band of the new range," he said. Crescenzi expects the range on the 10-year to be roughly 3 to 4 percent in 2011, though it is possible it could slip back below 3 percent.
"Early in the year, the economy is likely to be strong enough to keep people romanticizing about the idea of both higher inflation and a rate hike, and that'll prevent the yield from declining below 3 percent," he said.
While much of the wild action in bonds may be over for the week, O'Donnell said the year end may spur some buying before the end of Friday as traders square positions, and that may generate some more volatile moves just because volume is so light.
