It has been dubbed the "Great Rotation" – the seismic shift in markets as investors switched out of low-yielding bonds into stocks that were likely to benefit from US President-elect Donald Trump's potent cocktail of fiscal stimulus, tax cuts and reduced regulation.
But some analysts believe that the action in US markets this week suggests that investors are already getting cold feet about the benefits of the swap being over.
The Dow Jones Industrial Average edged lower overnight, after climbing to within 50 points of the never-before reached pinnacle of 20,000 earlier in the session. Investors appear to be waiting to see the detailed policies unveiled by Trump and the Republican-controlled US Congress. Hopes that the incoming administration will boost economic activity by increasing infrastructure spending and cutting taxes have pushed the DJIA up by more than 8 per cent since Trump's surprise electoral victory last November.
At the same time, the yield on US 10-year bonds held steady at 2.38 per cent overnight, a sharp rise from the 1.87 per cent level it was trading at last November. Since Trump's victory, investors have been selling US bonds on fears that stronger growth will spur inflation and force the US Federal Reserve to hike interest rates more aggressively, and this has pushed bond prices lower and sent yields sharply higher.
But, as billionaire bond investor Bill Gross noted in his latest Investment Outlook, the critical question for investors is whether the big moves since the November US presidential election have left markets out of kilter – with share markets too high and bond prices too low. "Are risk markets overpriced and Treasuries overyielded? That is a critical question for 2017."
Gross, who founded the giant bond fund manager PIMCO before his acrimonious departure to join smaller rival Janus Capital, argues that the rally in the US share market is based on the belief that the Trump administration will be able to achieve a "jump step move" in real US GDP growth, lifting it from the 2 per cent seen over the past 10 years, to a 3 per cent plus annual clip. The higher growth rate is hugely important for US corporate profits, which historically have advanced strongly at 3 per cent. In contrast, Gross notes that "2 per cent or less typically has smothered corporate profits".
Gross is sceptical that the US economy will achieve the faster growth rate, particularly since it is already close to full capacity in some areas. For the US economy to achieve a 3 per cent rate "would require a significant advance in investment spending which up until now has taken a back seat to corporate stock buybacks and merger/acquisition related uses of cash flow".
What's more, he notes that the US economy is also facing longer-term drag on growth from the ageing population, the high level of debt to GDP (even riskier given the rise in interest rates), the increased replacement of human labour by technology, while the "deceleration/retreat of globalisation pose negative ongoing threats to productivity and therefore GDP growth".
As a result, Gross argues that "Trump's policies may grant a temporary acceleration over the next few years, but a 2 per cent longer term standard is likely in place that will stunt corporate profit growth and slow down risk asset appreciation."
Stoke the fire
Gross then turns to the parallel question of whether US bond yields are too high. Although the Fed has started tightening monetary policy, having ended its massive bond-buying program in late 2014, Gross notes that other major central banks are continuing to buy bonds, and to "stoke the fire with as much as $US150 billion ($203.5 billion) of monthly buybacks".
According to Gross, the Bank of Japan's decision to target a zero per cent yield on 10-year Japanese bonds and the European Central Bank's continued dovishness "effectively caps the [yield on US 10-year bonds] at 2.4 to 2.6 per cent levels".
That's because even after hedging costs, major investors can still earn 70 basis points by selling 10-year Japanese bonds or German bunds and buying US 10-year bonds. This foreign demand for US bonds, he says, results in an "artificial pricing": for US 10-year bonds, "even as inflation moves higher and short-term yields are raised by the Fed once, twice, or even three times in the next 12 months".
Gross notes that for the past three decades US bond yields have been steadily falling lower. Since their peak in the early 1980s US 10-year bond yields have been falling by 30 basis points on average each year. This has pushed the yield on US 10-year bonds from 10 per cent in 1987 to around 2.4 per cent.
But Gross points out that this strong downward trend line is now at risk of being broken, if the yield on US 10-year bonds moves above the 2.6 per cent level. He cautions investors that "if 2.6 per cent is broken on the upside – if yields move higher than 2.6 per cent – a secular bear bond market has begun.
"Watch the 2.6 per cent level. Much more important than Dow 20,000. Much more important than $US60-a-barrel oil ... It is the key to interest rate levels and perhaps stock price levels in 2017."
But not all investors are convinced that Gross has his maths right. Rising bond market star, Jeff Gundlach, who runs the $US100 billion DoubleLine Capital, says that investors should watch out if the yield on US 10 year bonds rises above 3 per cent.
"I think above 3 per cent is a problem", Gundlach told Reuters. "If the 10 year goes above 3 per cent, you would have to say unequivocally you have seen the end of the bond bull market."
