Long Secular Bull Market In Bonds Could Be Ending

by The Curmudgeon

In his latest Investment Outlook, entitled “There Will Be Haircuts,” PIMCO co-CEO Bill Gross wrote: “PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not ‘good money,’ they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.” He then advises: “Give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.”


On May 10th, Gross tweeted, "The secular 30-yr bull market in bonds likely ended 4/29/2013. PIMCO can help you navigate a likely lower return of 2 - 3% in the future."


A bond bear market, typically defined as a 20% decline in prices, “will not occur in 2013,” said Gross in an e-mail response to questions from the Wall Street Journal.  Evidently, those comments extended a recent selloff in the U.S. government bond market, which greatly surprised THE CURMUDGEON!  Just 2 weeks ago, the 10 Year Note and 30 Year Bond yields made new lows for the year.  Those Treasury yields are now the highest since late March as you can see from this chart of the benchmark 10 Year Treasury note:


Chart forCBOEInterestRate10-YearT-Note (^TNX)


Meanwhile, Warren Buffett's Berkshire Hathaway is selling bonds. Its Finance Corp. sold five-and 30-year securities offering the company's lowest coupons for those maturities ever. Berkshire, whose holdings span insurance, railroads, newspapers and manufacturing has reduced its bond investments to $28.6 billion from $34.1 billion in the last three years, regulatory filings show.


Berkshire isn't buying corporate bonds, Buffett said during a May 4th interview with Bloomberg Television's Betty Liu after the company's annual meeting in Omaha, Nebraska. With the average yield on U.S. corporate debt having fallen to a record low 3.35 percent this month from more than 11 percent in 2008, the second-richest American said at the meeting he has empathy for savers who depend on bond interest.


"Buffett's views on current interest rates are pretty clear," said Richard Cook, co-founder of Cook & Bynum Capital Management LLC in Birmingham, Alabama, which oversees about $270 million including Berkshire shares. "Berkshire issuing debt is effectively an efficient way to short the bond market."


The CURMUDGEON thinks highly of Warren Buffett, who would not permit Berkshire to issue long-term debt if he was not convinced that US interest rates have bottomed and will start to rise in the next year or two.


Concern about a sudden surge in interest rates has been around ever since the Fed drove short-term rates close to zero in December 2008, ebbing and flowing depending on the economic outlook. The Fed has also amassed over $3 trillion in assets in an effort to spark a self-sustained recovery.  But it has instead inflated financial assets like stocks and bonds of all types and duration.


Ethan Harris of Bank of America said that he is worried if inflation starts to pick up in earnest. “If that happens, just as the Fed starts to normalize its balance sheet, policymakers will face some very tough choices. Our credit analysts also worry about credit spreads widening. In 1994, credit spreads were relatively stable but the risk today is that the inflow into credit reverses sharply, causing credit spreads to widen even as Treasury yields rise. The overall loss for bond investors may be greater than the 10% loss in 1994.”   Harris said that the Fed will have to be careful about how quickly it exits and may decide to increase interest on reserves rather than sell bonds.


In a missive entitled, "The Point of No Return,"  commenting on the huge problems of an ever expanding Fed balance sheet, Bob Eisenbeis of Cumerland Advisors wrote: 


"The problem for the FOMC may not be how to exit, but rather how long it can continue its asset purchase program before its balance sheet becomes too big and the supply of outstanding securities, especially Treasury securities, become so limited that markets like the repo market and others that rely upon collateral to function finally reach a breaking point.  As of February 2013, foreigners own about half of the $11.9 trillion of publicly held US Treasury debt, while the Fed owns about 15%, or another $1.8 trillion.  Fed purchases of Treasuries at their current pace of $45 billion per month will add another 5 percentage points per year to the Fed’s ownership share.  Interestingly, these percentages are not far off from the aggregate percentages for the distribution of the ownership of sovereign debt issued by the major central banks of the world."


In conclusion, we see the possibility that either a sudden inflationary shock or a pickup in credit demand could cause a sharp spike in interest rates that would be very unsettling for the equity markets and real economy.


Till next time.....................................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.