Sunday, February 24, 2013

Bond Price Relationship

This is the 2nd post on this Topic. First post gives a background about Bonds and their pricing strategies. It can be read here.

Reasons for Bond Price rise (Both of these reasons are valid for the US Bond Bull market): 
  • Prices will rise if interest rates go down e.g. Federal Reserves lowers the interest rate or we have deflationary pressures.
  • Prices will rise if there is extra demand (supply/demand curve -  Higher Demand = Higher Price). This typically happens under two scenarios: 1- Economy is doing well, and people feel that they will get the returns promised by the country. As a result, they buy bonds as investment (Economic Confidence Trade). 2- Everything else is doing so bad that investors don't have any choice but to buy bonds (Fear/Safety/Risk off Trade).
These reasons can be inverted to suggest why Bond Prices Fall:
  • Prices will decline if interest rates go up e.g. Federal Reserves increases the interest rate or there are inflationary pressures in the market. Inflation typically happens in a good/robust economy (not always).
  • Prices will decline if there is lesser demand (Supply/Demand curve -  Lower Demand = Lower Price). This typically happens under two scenarios: 1- Economy is doing very poorly, and people feel that they will not get their money back from the country. As a result, they will dump their bonds (This was seen in Europe in 2012, where the Bond prices fell along with the Stock Market, and the yields reached 6% for some countries, which had to seek bailout funds). 2- Everything else (commodities and stocks) are doing so good that investors don't have any choice but to sell bonds (Rotation/Risk on trade).
Based on the above mentioned explanation, lets analyze the U.S. Bond market. 

US Bond market has been going up because U.S. Bonds were considered safe haven during the financial crisis of 2008 and during the 2012 European crisis. This situation was further amplified by Federal Reserves extra low interest rate policy, and the subsequent QEs. Finally, there is a 30 year cycle in the Bond Markets. This cycle bottomed in 1980 and will be topping out soon. All of the above reasons have contributed towards a Bond Market's Bull run. 

Bond's Relationship to Stocks:
Some argue that when Bonds go up Stocks go down (inverse relationship) because investors (small and large) shift their investments from bonds to stocks (Rotation / Risk on trade). This is the same argument that is being given right now in the form of "The Great Rotation." According to this thesis people will sell their bonds, and will put money into the stocks.

However, the inverse relationship is not true in the long term. For example Bond Bull is started in 1980, but during this time we have seen a secular Stock Bull Market (1982 to 2000) and are now witnessing a secular Stock Bear Market for the last 13 years (2000 to Present). As mentioned above, it is also possible for stocks to decline in sync with bonds. This will happen when people lose confidence in the government (recent European Example). 

Current Situation:
Commodity markets' price action is suggesting Deflationary pressures are coming back. Deflation means bad economy and lower yields due to both poor economy (safe heaven trade) and low inflation rate. Lower yields result in higher bond prices. This would negate the concept of "The Great Rotation."  In fact, this might suggest that stocks might soon experience a decline. For all those who have been patiently waiting to short bonds: That time will come (probably within 1-2 years), but it seems like its not now!!

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