Santoli: The big question facing investors today

Published Sun, Sep 11 20169:39 PM EDT

The abrupt jump in bond yields around the world last week has challenged a core premise of the investment scene and forces this question: "Is the ultimate low in interest rates finally in the books?" The most honest answer is, nobody knows, and it's even a bit premature to venture a confident prediction. While the 10-year Treasury yield is up decisively from a July low of 1.36 percent, rising to 1.67 percent amid growing anxiety about central-bank intentions, it remains below where it traded before the U.K.'s June 24 vote to depart the European Union - and well beneath the 2.27 percent level where it ended 2015. Still, the sell-off in bonds has been global enough and comes from such extreme levels that it's worth running through the sentiment, policy and fundamental factors that could determine whether this is a fleeting backup in the cost of money, or the end of the powerful 35-year trend of lower rates. Was the "rising rates" chorus wrong enough for long enough that they could see their prediction come true, soon after they quit singing it so loudly? After years in which the consensus incorrectly predicted that bond prices would drop (sending their yields higher), forecasters coming into 2016 had made an uneasy peace with ever-lower rates as central banks ran ultra-easy monetary policies, experimented with negative rates and became huge buyers of debt. "Lower for longer" became the mantra. Investors threw more than $104 billion into bond funds in the first half of the year and yanked $84 billion from stock funds. It seems as if everyone prefaced a view on any investment by quoting how many trillions of government debt around the world had a negative yield, as if it permitted virtually any valuation on other assets. Big companies are preparing to issue debt at a negative yield to the European Central Bank. And, just for fun, celebrated social-media startup Snapchat – still resisting calls to sell stock to the public – last week began marketing a debt offering. So the case can be made that bonds are frothy and over-loved – even if they're not animated by the "get rich quick" stories that float a classic bubble. As ConvergEx chief market strategist Nick Colas says, "Markets of all stripes (stocks, bonds, currencies) are locked into a 'Fade the Fed' mentality that heavily discounts the possibility of a rate increase before the December meeting." Or, at least this was the case until a few days ago. Speeches by Federal Reserve Bank presidents Eric Rosengren of Boston and John Williams of San Francisco last week were seen as trying to convey the chances of an interest-rate boost after the next Fed meeting on Sept. 21. And a hastily scheduled speech Monday by steadfast Fed dove Lael Brainard thickened the plot, with some viewing her as a possible decisive voice if Chair Janet Yellen wants to prepare markets for an imminent move. Ben Hunt, chief risk officer at investment advisor Salient, said Friday: "I think the Fed will hike at the upcoming September meeting and then go on a narrative blitz to say this isn't part of a tightening program. Right now, the Fed's missionaries are out in full force. And yesterday, [ECB President Mario] Draghi held his fire, which central bankers think will keep the post-hike dollar strength from getting out of hand." Yet a reassessment of the Fed's near-term plans is only one element of the broad lift in bond yields – and possibly not the most interesting one. The most dramatic move in yields Friday came in longer-term Treasuries, not the two-year note, which is most sensitive to Fed policy changes. And, as Hunt notes, it got rolling earlier in the week when the European Central Bank chose note to extend its existing bond-buying plan past March, as some had hoped and bet. All this fed into a gathering sense of central-bank fatigue - a sense that perhaps these institutions were nearing a point where they felt further action was undesirable or unlikely to be effective. DoubleLine Capital's Jeffrey Gundlach, who last week insisted the ultimate low in yields was in, points to growing calls for fiscal stimulus. And the talk of raising the Fed's de facto inflation target is also a message that the winds might be turning against bondholder interests. Nothing much more than the market's outlook on inflation and the demand for "safe" assets determines a bond's trading price. Yet an old rule of thumb states the 10-year yield tracks nominal gross domestic product over time. If this pattern returns, that yield would head well above 2 percent, perhaps toward 3, especially as oil prices stop depressing headline inflation. Still, the iShares 20+ Year Treasury ETF , the popular bond-market proxy, is only down 5.6 percent in price from its all-time high on July 8, and remains up 11.6 percent over the past year. If it were a growth stock undergoing a pullback, it's easy to imagine analysts saying a buying opportunity was at hand. The tricky part of the current environment is just how low yields have been, and how relatively expensive stocks appear at the same time. As I noted in a recent column, the financial markets don't necessarily owe investors much at this point . So, relatively modest jumps in bond yields mean painful losses for their owners, and potentially radical adjustments to valuations of things such as stocks. Friday, the 30-year Treasury sank by nearly 3 percent in price – costing any recent buyer more than a year's worth if income. The utilities-stock sector and the S & P 500 as a whole gave up the equivalent of a year's dividends that day too. Maybe the bond selloff is another passing tantrum. The Fed could easily shift back to a soothing message, or election jitters and growth worries could put a bid back in bonds. Still, if nothing else, the past week could be viewed as a test run for the day when the "lower for longer" pillar beneath financial markets cracks, and stock investors would need to fashion a new narrative for why this bull market has more life in it. It's possible for such a pivot to a fresh story line to occur, but they rarely occur without some uneasy plot twists.

Ramin Talaie | Corbis | Getty Images

The abrupt jump in bond yields around the world last week has challenged a core premise of the investment scene and forces this question: "Is the ultimate low in interest rates finally in the books?"

The most honest answer is, nobody knows, and it's even a bit premature to venture a confident prediction.

While the 10-year Treasury yield is up decisively from a July low of 1.36 percent, rising to 1.67 percent amid growing anxiety about central-bank intentions, it remains below where it traded before the U.K.'s June 24 vote to depart the European Union - and well beneath the 2.27 percent level where it ended 2015.

Still, the sell-off in bonds has been global enough and comes from such extreme levels that it's worth running through the sentiment, policy and fundamental factors that could determine whether this is a fleeting backup in the cost of money, or the end of the powerful 35-year trend of lower rates.