Are Bonds Ready To Pick Up Steam?

Signs of a slowing economy bode well for a real rally

There's just no stopping the stock market, it seems. The potent mix of solid economic growth and rising corporate profits, coupled with remarkably low inflation, is taking stocks to places they have never gone before. The Dow Jones industrial average, at 7,719 on June 18, is up almost 1,300 points this year, nearly 20%. Almost a third of that rise came in the last three weeks. The Standard & Poor's 500-stock index is keeping up the Dow's torrid pace, and over-the-counter stocks are reaching new highs as well.

But the rocket fuel that's propelling stocks hasn't gotten bonds off the ground. True, the bond market has rallied in the last three weeks, slicing the yield on the benchmark 30-year U.S. Treasury from a little over 7% to 6.68%. But that still leaves long-term bond prices a little more than 1% lower than they were at the beginning of the year, while prices of 10-year Treasuries are about where they were in early January. Overall, the bond market is up a little over 3%, including interest income.

Nothing seems to stir bond investors. Not the smallest budget deficit in nearly two decades, and not the prospect of a balanced budget. Even real, after-inflation yields of 4% fail to inspire buyers. "So far this year, we've had five negative producer price index numbers, no inflation, spectacular deficit numbers, and a Fed that pulled the trigger and tightened and can't find a reason to do it again," says James A. Bianco, Arbor Trading Group's research director. "We've had terrific news in the bond market, and we're higher in yields now than when we started the year. If you're going to tell me bonds are a good buy because of all that, well, that stuff has been happening and it ain't working."

But listen up. Some savvy strategists think that in the next few months, the bond market could start its rise. The stage has been set. Inflation remains in control, and with the federal government borrowing less, the supply of bonds is shrinking. Now, there's a trigger: Bond analysts see evidence of slower growth ahead--a signal that interest rates could start to drop. Indeed, on June 18, the Federal Reserve reported that "pockets of weakness" already appear to be developing in manufacturing, retail sales, and construction. Charles I. Clough, chief investment strategist for Merrill Lynch & Co. points to the sharpest slowdown in consumer-credit growth since 1990 and three straight months of falling retail sales. "If we get a few more signs like that, the bond market can take off like a bullet," Clough says.

How far? Former Fed economist Mike Astrachan, who runs a Tel Aviv-based economics consulting firm, thinks long-term yields may fall below 6% this year. "Bonds might even get to 5% if you get two quarters of 2% GDP growth," he says. That would drive up the price of a 30-year bond about 22%.

TWO CAMPS. Still, the notion of long bonds at 6%--let alone 5%--remains a tough sell to many fixed-income folks. While stock market bulls believe in the so-called new economy--a golden era in which technology drives productivity and permits strong growth and low unemployment without triggering inflation--the bond crowd is more pessimistic. The chief worry: The economy is too strong and unemployment too low for inflation to remain at bay for long. Indeed, what separates the bond-market bears from the bulls is "whether you think the `golden era' effects are temporary or whether you think they are long-lasting," says Frank Trainer, chief of taxable bond investments at Sanford C. Bernstein & Co. and a bear on bonds.

Another bear is Ian A. MacKinnon, who oversees $93 billion in bond funds at Vanguard Group. "With the economy running as full as it is and the labor markets as tight as they are, sooner or later that will get passed on to the consumer through higher prices," he says. MacKinnon has replaced some longer- term bonds with shorter ones in his funds to lessen the impact of the rising rates he anticipates: He's figuring long-term rates of 7.25% by yearend--higher than they've been in two years.

But fundamental and technical factors point to a rally. Merrill's Clough, for example, suggests that $800 billion in bank CDs and other short-term instruments that have accumulated over the last three years could easily shift to bonds as investors seek higher returns. "When you can get 5% in the money market, you don't need bonds," says Clough. But if even one-tenth of that short-term money is reinvested in bonds, he says, the impact on the market will be astounding.

Another factor pointing to a bond rally is the supply-and-demand situation. The federal deficit, which approached $300 billion as recently as five years ago, looks like it will come in around $75 billion for fiscal 1997. That's roughly the amount of money Treasury will have to cover by issuing debt. Last year, for comparison, Treasury had to finance a $107 billion deficit. It's true that the rate of corporate bond issuance is up about 6% over last year's rate. However, that still doesn't compensate for the cutback in Treasury issues, says Elliott Platt, fixed-income strategist for Donaldson, Lufkin & Jenrette Securities Corp. Meanwhile, borrowing in the municipal bond market is actually running about 13% below the level of 1996.

Then there's the influence of overseas investors. In the first two months of this year alone, foreign investors increased their Treasury holdings from $1.13 trillion to $1.18 trillion, about 4%. And yields remain high enough in the U.S. to continue to attract these buyers. Ten-year U.S. Treasuries, at 6.39%, whomp the 2.6% yields on comparable bonds in Japan and beat out those issued by Canada, France, Germany, and even Spain.

NO SELLERS LEFT? Bearish sentiment itself is a signal to some analysts that it's time for a bond rally. Since January, 1994, investors have shoveled $470 billion into equity mutual funds but liquidated $35.6 billion in bond funds. "Bonds are definitely the unloved asset," says Vanguard's MacKinnon, one of the few bond fund managers experiencing net inflows this year. However, in markets, extreme positions are often wrong. When everyone hates a particular investment and expects it to go down, the price often goes the other way. That's because anyone who wants to sell those assets has already done so, leaving only potential buyers.

Government bonds are perhaps the most unloved of all. Investors who have bought bonds in recent years have snapped up corporate bonds and high-yield and emerging-market debt. That has driven the "spreads"--the difference between the interest rates earned on Treasuries and rates on other debt--to such low levels that many bond analysts believe that investors are not earning enough yield to compensate for the additional credit risk they take on in non-government bonds.

Some investors might be delaying a decision to buy bonds until the Fed's July 2 meeting lest the central bank tighten monetary policy yet again by pushing up short-term rates a second time this year. However, Edward M. Kerschner, chief investment strategist at PaineWebber & Co., counsels against waiting. In each of the last seven rounds of tightening, he says, yields peaked and bond prices bottomed out before the last Fed tightening. For the bond bulls, the time to buy is now.