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Worst Trade of the Year? Bet Against Bond Market

Tuesday, 19 Feb 2013 | 1:11 PM ET
Tetra Images | Getty Images

While going long the stock market has been a great trade so far in 2013, betting that the bond market would suffer as a result could be the worst.

True, equities in a broad sense have outperformed their fixed income counterparts.

But the so-called Great Rotation trade that many market professionals had been looking for has failed to show any signs of materializing.

"Redistribution is not the same as rotation," said Kevin Ferry, president of Cronus Futures Management in Chicago and a trader not in the Great Rotation camp.

Ferry's point is not an arcane one - indeed, it goes to the heart of whether the 2013 market will be driven by an accelerated risk-on trade that finally will fulfill all those prophecies that the bond bull market is over, or if the safety play remains viable for investors' portfolios even if the stock market grows.

(Read More: Money Pouring Into Stocks 'Is Usually a Negative Sign')

The rotation play holds that investors will reverse four years of money flowing out of equities and into bonds.

So far, flows show that only half that trend has occurred.

In the first month and a half mutual funds that invest in stocks have taken in a robust $43.8 billion, a post-financial crisis high. If the rotation theme held, it would be likely to see a similar amount come out of fixed income mutual funds.

Bond Market Still Very 'Robust': Trader
Kevin Ferry, Cronus Futures Management, provides a look at what traders will be watching ahead of the market's open.

Instead, bond funds have taken in $37.6 billion - less than equities to be sure, but still a strong allocation and not indicative of a pronounced move out of bonds and into stocks.

So where has the equity side gotten all this money?

Money market funds - the dead pool that became so popular after the crisis - have lost $37 billion so far, helping explain the boon to stocks, and revealing an investor mentality in which the stock market is seen as a much better store of wealth than the zero-yielding alternative.

This has been pretty much the whole idea as the Federal Reserve has rolled through three rounds of bond buying known as quantitative easing designed to force yields down so much that investors will have no other choice but to seek out risk.

"It works until it doesn't," Ferry said. "That's what QE does - it turns the capital markets into an ATM machine. As long as there's not an exogenous event, you're OK."

(Read More: Central Banks Gone Wild: What Can Investors Do?)

If there has been a rotation, in fact, it probably is more from safer fixed-income instruments such as the benchmark 10-year Treasury note into higher-yielding bonds such as corporate junk.

Broadly, bonds as measured by the Barclays Composite Index have returned about 3 percent in 2013, but Treasurys have lost 3.5 percent. Corporate high-yield has returned 1.3 percent, while dividend growth is up nearly 6 percent.

Conversely, the Standard & Poor's 500 stock market index has gained 6.5 percent.

(Read More: Spending Cuts Loom as 'No. 1 Threat' to Market)

Looking purely at fund flows, exchange-traded products have seen about $1.2 billion come into bond funds, but double that for higher-yielding riskier offerings.

Ferry said the bond market actually has performed efficiently this year, with yields rising but in tandem, indicating that the yield curve remains constructive.

Still, Bank of America Merrill Lynch, one of the loudest proponents of the Great Rotation, insists that the trade is only in its early days even if appearances suggest otherwise.

"The Great Rotation theme is risk supportive, but even assuming volatility stays low and the macro remains in a trading range, the best outcome is for equities and other risk assets is to grind higher in coming months," Michael Hartnett, BofA's chief investment strategist, said in a note.

The firm is bullish on high yield, neutral on government bonds in emerging markets, and bearish on government, investment grade and similar traditional safe-haven bets.

Bond dealers have $47.6 billion in short positions on Treasurys, the highest level since before the crisis, according to RBC.

Meanwhile, a BofA sentiment indicator is now more bullish than 99 percent of its readings since 2002, Hartnett said, and the firm itself, despite espousing the Great Rotation theme, believes that bonds are not heading for a crash.

The bearish levels on Treasurys and bullishness on stocks are both approaching contrarian levels, meaning that the unraveling of both trades could be near.

So investors looking to position for the times ahead by betting heavily on stocks in anticipation of money rolling out of bonds may want to hold off.

"The disconnect between weak economic fundamentals, ebullient investor sentiment and elevated stock prices form an unhealthy and potentially toxic cocktail," said Doug Kass, head of Seabreeze Partners. " I am as bearish on stocks as I have been in some time."

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