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GOING LONG
The Slam Dunk That Wasn't
by Jeremy J. Siegel
I remember it well. Last March and April, everyone was certain the economy and inflation were headed upward. Businesses were adding employees at a rate of more than 300,000 a month, oil prices were headed higher and the Fed prepared to order the first increase in short-term rates in nearly four years. Everyone was certain that long-term interest rates would rise, and rise substantially. Experts said that the ten-year Treasury-bond rate, which had been below 4% in March, would reach 5% to 6% by the end of the year. Everyone said to lock in fixed-rate mortgages now and sell all our bonds. Everyone was wrong. Long-term rates, at almost 5% in May and June, tumbled below 4% in October and are about where they stood when the year started. What happened?
The herd effect
When "everyone" thinks that the market is headed in one direction, you may be better off on the other side. The reason is straightforward. For example, if everybody thinks a stock or bond is going up, then most will have already bought that security and there will be few new buyers left. At the first whiff of bearish news, those who bought will sell and prices will fall.
So last spring, everyone was bearish on bonds and had already sold their positions. In fact, many hedge-fund managers, trying to take advantage of the "inevitable" rise in rates, sold bonds that they didn't even own, making leveraged bets that the bond market had to fall. (Bond prices fall as rates rise.) Again, if there was any news to disturb this bearish scenario, you could count on these traders to cover their positions and start buying bonds back.
Much to the discomfit of the consensus, there was good news for bonds. Inflation in oil and other commodities didn't spread to other goods. Economic growth slowed, as the economy decelerated from its 4.5% growth pace in the first quarter to just over 3% in the second. Furthermore, the job-creation rate slowed markedly.
Another reason for the bearish prediction on bonds was that traders were thinking back to 1994, when the Federal Reserve Board raised short-term interest rates after a prolonged stretch of keeping rates low. At the time, the Fed was forced to raise rates rapidly. After abandoning a 3% rate that had prevailed for 18 months, the Fed raised the rate to 6% in a matter of months. A slowing economy and tame inflation makes this year's run-up in short-term rates modest in comparison.
Let's not forget China, either. As the world's fastest-growing economy, China churns out a record volume of low-priced goods, and those low prices help offset the inflationary impact of the rise in the price of oil and gas. Furthermore, with the dollars it receives from goods sold to the U.S., China is a huge buyer of U.S. government bonds. Over the past four quarters, foreign investors have increased their holdings of U.S. Treasury securities by $413 billion, or more than the actual increase in our national debt (excluding the sale of savings bonds). Many of these purchases, which have helped to hold down interest rates, come from Asian central banks.
Now the bad news
It's tempting to say bond prices will remain strong (and long-term rates low). I'm afraid that won't happen. The bearish consensus in the bond market is not as strong as it was six months ago. I think economic growth will reaccelerate and price pressures, especially from oil costs, will increase.
This doesn't mean that bonds will fall out of bed or that interest rates will soar. But it does mean that 5% is closer to where the long-term rate should be, given stronger growth and rising inflation. This trend will give stocks a decided edge over bonds in the months ahead.
Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run. |
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