Bond markets have undergone an interesting change since this summer.
Lately, yields on most types of fixed income have risen.
This could imply a number of things, but a likely culprit is encouraging economic data.
A great deal of attention has been paid to bond markets this year. Most news has centered on European government bonds (which we've frequently covered, like here)—but it's been a very interesting year in bond markets elsewhere too. This year has been marked by ultra-low interest rates, exemplified well by a three-year IBM corporate bond issued at 1% this summer (you read that right: Investors lent to a corporation money for three years in exchange for 1%), and US Treasury yields have been even lower for much longer. But recently, bond market action tells a different tale—rising yields.
Since early October, US treasury yields have jumped. Ten-year Treasury yields, while still historically low at 3.319% as of Friday, have risen nearly 1% since early October. In fact, while some expected the Fed's QE2 to keep long rates low or even bring them lower, the bulk of the upward move has occurred after QE2's announcement. German bunds, widely considered the least risky government debt in Europe, have also seen rising yields lately. Some may interpret German yield moves a byproduct of the eurozone's much-discussed sovereign debt issues, but considering this move coincides with treasuries and corporates, that assumption seems shaky.
So what's driving yields higher? As with stocks, there are many potential inputs behind the increases, but encouraging economic data is a likely culprit. Since November, data has shown strong US holiday shopping, robust manufacturing statistics globally, a eurozone stronger than widely thought, and plenty of other data pointing to continued economic growth. The improving economic picture quells deflation fears and might have some investors more concerned with future inflation—and corresponding higher central bank rates down the road. And no doubt, despite Fed Chairman Ben Bernanke's best efforts on "60 Minutes" recently, QE2 and a possible QE3 likely fuel those concerns.
Continued economic improvement globally also emboldens investors to take on more risk, so some may be exiting government bonds in search of higher returns elsewhere. Since Treasury yields began their recent rise in October, the S&P 500 has risen roughly 7%. And the high-yield bond market has bucked the recent rising-rate trend—with yields falling lately. As prior fears of double-dip recession or a new normal have been gradually refuted by data, it appears investor focus is shifting from the perceived safety of high quality bonds to achieving better returns.
While significantly higher yields could pose a legitimate risk to the economy and stocks, interest rates are far from problematically high, and a quick move into troubling territory seems quite unlikely considering currently low inflation. But as economic growth continues—and confidence in the economy accompanies it—rates could gradually move higher. And while improved faith in the economy and decreasing risk aversion likely benefit stocks, those same forces are likely to weigh on fixed income returns, as yields and prices move inversely. As investors begin pondering things other than just credit risk (like earning more bang on their bond bucks or inflation possibilities), the highest-rated (and lowest-yielding) bonds could prove most risky.