Bond Rally That Wasn’t Supposed to Be Delivers Surprises

What a difference a month makes in the bond market.

After suffering their first losing month this year in September, fixed-income securities of all types worldwide are back on track in October to deliver their biggest annual returns since 2002 based on Bank of America Merrill Lynch indexes. Yields fell to an average 1.62 percent yesterday, down from 2.09 percent at the end of 2013 and the lowest in 17 months.

Investors betting that September’s losses were the start of the long-awaited bear market in bonds were caught off guard this week by a string of developments worldwide that suddenly put in doubt notions that the Federal Reserve would raise interest rates sooner rather than later. Those range from new signs of potential deflation in Europe to the International Monetary Fund cutting its global economic forecasts and the Fed warning that the strong dollar may curb growth in the U.S. and elsewhere.

“Everything has changed fast,” said Andrew Brenner, the head of international fixed income for National Alliance Capital Markets. “The market has been caught by surprise by the Fed’s global growth emphasis.”

Seeking Safety

Led by the safest sovereign debt such as U.S. Treasuries and German bunds, bond returns this month totaled 0.67 percent through yesterday. With fewer than 60 trading sessions left in the year, the market is on pace to post an 8 percent gain, the most since 2002’s 8.9 percent. Stocks have returned just 1.8 percent after dividends based on the MSCI All-Countries World Index.

This year’s rally in the bond market has caught most everyone by surprise. That may be best seen in the benchmark 10-year U.S. Treasury note yield, which ended 2013 at 3.03 percent. At the time, the median estimate among more than 60 economists surveyed by Bloomberg was for it to rise and end this year at 3.44 percent as bond prices fell. Instead, the yield fell to 2.31 percent yesterday, with the latest survey showing the forecast has been reduced to 2.7 percent.

This week’s rally took hold after the Washington-based IMF cut its outlook for global growth to 3.8 percent next year from a July forecast of 4 percent.

‘Off Guard’

A number of Federal Open Market Committee policy makers said U.S. growth “might be slower than they expected if foreign economic growth came in weaker than anticipated,” according to minutes from the Sept. 16-17 meeting released this week. In a statement following that gathering, policy makers renewed their pledge to keep interest rates near zero for a “considerable time.”

“Sentiment has changed in the bond market,” said Donald Ellenberger, who oversees about $10 billion as head of multi-sector strategies at Federated Investors in Pittsburgh. Investors “were caught off guard by all the global growth issues.”

As the Fed prepares to wind down unprecedented stimulus measures this month that have suppressed yields, the European Central Bank is gearing up for monetary expansion via a form of quantitative easing amid weaker-than-forecast growth. Data this week showed German exports, factory orders and industrial production each slumped by the most since January 2009 in August, adding to signs Europe’s largest economy is struggling.

‘One Direction’

“For fixed-income markets there is only one direction, and the main impetus is the ECB,” said Werner Fey, a fund manager at Frankfurt Trust Investment GmbH, which oversees about $21 billion. “As long as speculation on QE is still alive, we will continue in this direction.”

Investors are favoring the safest debt securities over riskier assets such as speculative-grade corporate bonds on concern that prolonged economic strains will hamper the ability of companies to repay obligations. The average yields on junk bonds now exceed those for higher-rated companies by 3.8 percentage points, the most in more than a year and up from a 3 percentage-point gap in June.

Yields on Germany’s 10-year bund, the euro region’s benchmark sovereign security, fell to as low as 0.858 percent yesterday, the least on record and down more than 1 percentage point since the end of 2013. That compares with an average 2.92 percent during the past decade.

Fed Distortions

Even for the U.K. economy, which the IMF this week said would grow more than all of its G-7 peers this year, the outlook is darkening, prompting traders to push long-term yields to the lowest in more than a year. As recently as June, investors were selling the bonds as Bank of England Governor Mark Carney said rate increases “could happen sooner than markets currently expect.”

The central bank interference is distorting the market and forcing some investors to chase higher returns with riskier assets, Jack Malvey, chief global markets strategist at Bank of New York Mellon Corp., said in a telephone interview.

“We again and again see people who are not well-versed with capital market history chasing bubbles, talking about a new era and a new paradigm,” said Malvey, who started working in the credit markets in 1975. “We’ve all been waiting for higher interest rates like waiting for Godot.”

The Fed’s record stimulus has expanded its balance sheet to $4.45 trillion from less than $1 trillion in 2008 in an effort to stimulate growth after the global financial crisis. The Bank of Japan is buying debt and expanding its monetary base by as much as $650 billion a year, and the European Central Bank announced plans to purchase covered bonds and asset-backed securities.

“The rally in bonds is being driven by the fear that the growth outlook is worse than we thought and worsening,” said Bonnie Baha, director of global developed credit at Los Angeles-based DoubleLine Capital LP, which manages about $56 billion. “Where is the catalyst for the uptick in economic growth?”

Before it's here, it's on the Bloomberg Terminal.