Bond Market Facing Scrutiny; Why Stocks Could Face Same Future

Bond MarketOver the past few years, buying bonds was the trade. Be it government bonds, municipal bonds, or high-yield corporate bonds. Thanks to the Federal Reserve, every time interest rates were lowered, or every time there was an announcement of new quantitative easing by the Fed, bond prices soared and investors in those bonds made a lot of money.

Now bond investors aren’t looking so happy. The Federal Reserve, with its repeated statements about raising interest rates this year, has sent bond prices down and investors in U.S. bonds have been running for the exit door for weeks now.

According to the Federal Reserve, the bellwether federal funds rate is expected to increase to 0.625% this year from its current 0.25%. Then, it’s expected to rise to 1.625% in 2016, and reach 2.625% by 2017%. (Source: Federal Reserve, March 15, 2015.)

Understand this: the hike in the federal funds rate may not sound like much, but on a percentage basis, between 2015 and 2017, interest rates set by the Federal Reserve are expected to increase by 950%! Rising interest rates are bonds’ biggest enemy. As interest rates rise, bond prices plummet.

Bonds Yields Soaring

Just look at the chart below of the yield on the 10-year U.S. Treasury Note.

In 2014, bond investors had a great year. Yields on bonds declined and bond prices increased. But since February of this year, we have seen the bond market completely turn. Yields on the 10-year notes have jumped 40% in less than four months.

The downtrend in yields that began in early 2014 (black line) has been broken. Ask any technical analyst, and they will tell you: “The trend is your friend, until it’s broken.” In other words, don’t be shocked to see yields on bonds move higher, thus pushing down bond prices further.

10 Year Treasury Note Yield Chart

Chart Courtesy of www.StockCharts.com

Great Rotation From Bonds to Stocks Coming?

With the sell-off in the bond market, there’s a significant amount of noise regarding investors moving from bonds to stocks. This was talked about back in 2013 as well, when the Federal Reserve was expected to reduce its pace of money printing. It was coined as the “great rotation.”

I questioned this theory then, and I do the same now.

Stocks have become dangerously overpriced. They are significantly overvalued according to historically proven stock market valuation tools. See just one example here where investors are paying a ridiculous amount of money for equities: http://www.profitconfidential.com/stock-market/stock-market-valuations-and-optimism/.

Stocks are reaching their peak when looking at investor psychology and behavior. Read more on this here: http://www.profitconfidential.com/stock-market/stock-market-reaching-top-four-reasons-to-be-worried/.

Investors would have to be completely irrational to jump to stocks to protect their money from the declining bond market.

What’s Really Ahead?

Just as the bond market has seen a significant rise due to low interest rates, stock markets have risen, too. Low interest rates have created a capital misallocation in both of these markets. As interest rates rise, they will take down both the bond market and stock market.