The recent bull market in U.S. bonds has been one for the record books and by our way of thinking now seems to belong in the history books. Beginning in 1981, with the 10-year yield close to 16% and the federal funds rate approaching 20%, U.S. Treasury bonds have experienced slightly more than three decades of steadily declining yields and commensurately rising prices. In fact, entering 2012, bonds had outperformed stocks over this 30-year period by a healthy margin: certainly a rare, if not unheard of, winning streak. Over that time, there was a dramatic shift in the posture of the U.S. Federal Reserve as the restrictive monetary policies used to combat the hyper-inflation experienced in the late 1970s gave way to a prolonged period of monetary easing that redefined the role of central banks in combating economic shocks and bouts of asset price deflation.
In response to a range of economic and systemic challenges, including the stock market crash of 1987, the collapse of Long Term Capital Management in 1998, the bursting of the technology bubble in 2000, and most recently the global financial crisis that began in 2007, the Fed (joined by other central banks) engineered a series of creative, and at times controversial, monetary stimulus programs that culminated in interest rates hitting historic lows in 2012. Investors played their part as well as two stock market declines of more than 50% in the last decade alone, combined with enormous economic and political uncertainty, led to extreme risk aversion and a massive reallocation of assets away from stocks and into bonds, further fueling their price gains.
The 10-year Treasury hit its long-term low yield of 1.4% in April of last year, but interestingly its yield has been moving higher ever since. Ten months later, the yield is now slightly more than 2%. Has the bear market in bonds finally begun? If so, what impact will rising rates have on the stock market? While it is probably premature to predict a sharp increase in interest rates in the short term given the Fed's $85 billion monthly bond buying program and sustained zero interest rate policy, the building blocks for a move higher are already in place. Housing is clearly improving perhaps faster than currently reported. Unemployment, while not yet close to levels targeted by the Fed, is at least showing signs of stability. Auto sales are strong while industrial production continues to grow. Importantly, the stock market has picked up over the past year, which is both a valuable leading economic indicator and contributes to the stirring of "animal spirits" or increased risk taking that ultimately drives improvements in economic activity.
Over historical market cycles, rising rates have often signaled the market's expectation for rising inflation, typically a worrisome development for equities. However, what is different this time is the starting point for rates. Real rates are currently negative. Why? In the wake of the financial crisis, investors and the developed world's central banks have feared an even more potent adversary—deflation. As a result, interest rates have been manipulated to artificially low levels and the equity risk premium shot to a record high, where it currently remains.
Our view, which is at odds with the conventional wisdom, is that rising yields will be a positive indicator for both the economy and the stock market. Higher real rates would be a powerful signal that the economy is on sounder footing and no longer in need of the extraordinary measures currently implemented by the Fed. In fact, one could argue that there is plenty of room for yields to rise just to establish historically normal economic equilibrium before actually restricting business activity. In addition, rising yields often go hand in hand with increased risk taking and rising corporate profitability, historically healthy tailwinds for stocks.
One thing seems very clear—the Fed will not raise rates unless there is evidence of an improving economy and they are unlikely to allow them to rise at a pace that might jeopardize the recovery. The Fed has also become increasingly transparent, having given investors a roadmap for potential changes in monetary policy that should allow markets adequate time to adjust. In any event, rising rates occur naturally when business prospects improve, and some of the best times historically to own stocks have occurred when the economy is accelerating and rates are beginning to rise. We believe that this is one of those times.