Why the Bond Market Could Be in for a Bruising

Generals are always preparing to fight the last war, the old saw goes. Likewise, investors often try to avoid the last bubble -- leading to similarly dismal results.

Following a disastrous lost decade for the stock market -- during which stocks delivered their worst performance ever along with stomach-churning volatility -- investors bolted for the safer bond market instead. Inflows into bond funds reached record levels as high-profile bond managers like Bill Gross of Pimco, the world's largest bond fund, called for an era of a "new normal" where growth would remain lackluster for the foreseeable future.But as a surprisingly robust recovery shows signs of materializing, the legions of investors who scrambled for the safety of bonds could be the next to get hammered. Inflation and rising interest rates are generally major negatives for the bond market, but until recently both were considered highly unlikely because of massive unemployment's weight on demand. But a rate hike may no longer be such a remote possibility, some recent market action suggests.

Take Wednesday morning's trading ahead of the stock market opening. Stock futures pointed to a higher opening. But as soon as payroll-processing company ADP reported better-than-expected jobs data, stocks swung to a loss. The recently emerging pattern of stocks trading down despite stronger-than-expected earnings news could be a sign that some investors believe the Federal Reserve will raise interest rates sooner than is generally anticipated.

If Jobs Turn Around, Rates Could Go Up

The prospects for job creation -- full employment is one of the Fed's two mandates along with price stability -- and speculation that higher interest rates are on the way rose in the wake of December's surprisingly strong jobs report. A turnaround on the jobs front will have an even bigger influence on the Fed's interest rate decision than other positive recent data points, including a sharp manufacturing acceleration and surging GDP expansion.

If a robust recovery is taking shape, rising interest rates and less liquidity will no doubt weigh on the stock market. But stronger earnings will help mitigate some of that. Bonds, however, may be more exposed to downside in the current environment -- particularly if investors get nervous that exceptionally loose recent monetary policy and massive stimulus spending will lead to sharply rising inflation.

And it's the bond market where recently burned equity investors have been parking their money.

"Lopsided Numbers"

Despite the massive equity rally since the lows seen last March, about $4 billion a week has flowed into bond-related investments compared to $500 million a week for stocks, according to analyst Michael Belkin. Investments into bonds have piled up steadily to $178 billion, compared to buying and selling that has put a comparatively paltry net $24 billion into stocks over that period.

"I've been looking at this for quite a while and sort of scratching my head and wondering what was going on," Belkin has said regarding the lopsided numbers. But after "the public in previous cycles bought emerging-market funds or Internet stocks or whatever," bonds may now be the new bubble.

Continued evidence of a stronger-than-expected economic recovery could finally and suddenly decrease the recent popularity of bonds. Hint: Keep a close eye on January's unemployment data, which the government releases on Friday.
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