Stocks may be poised to deliver their best December performance in almost two decades, but it's the machinations in the bond market that have been captivating investors recently.
The question on market-watchers minds is this: Does the recent rapid rise in yields on U.S. government bonds signal a return to economic normalization, or are the nation's creditors finally getting fed up with financing soaring U.S. deficits? Both sides saw evidence to bolster their views this week.
The doomsayers got a major leg up on Dec. 28 following a tepidly received five-year Treasury auction that sent yields soaring.
But that auction may have been an outlier in a short week marked by light volume. Indeed, a seven-year note auction the next day fared better and saw indirect bidders -- including foreign central banks -- buy almost two-thirds of the offering, the highest level since June 2009.
While the wide daily swings make for attention-grabbing headlines, investors would be wise to look at the bigger picture instead. A mounting set of data suggests the U.S. economy is staging a far stronger recovery than most had predicted, and as the gloom clears, investor preference for stocks over bonds is likely to gain further steam. Also, concerns about inflation -- as opposed to the deflationary worries that pervaded Wall Street over the summer -- are likely to pressure government bonds further.
Threat From Bond Vigilantes Is Overblown
For the moment, there are plenty of reasons the world's savings continue to be funneled into the U.S. The American economy and financial markets remain ahead of the pack despite plenty of problems.
"Rising powers such as China are not yet ready to absorb the $9 trillion in reserve assets the world holds, particularly because their bond markets are immature," Anthony Crescenzi, a money manager at bond giant Pimco wrote in a report this week. "Europe, amid all of its financial woes, isn't even close to ready to take the mantle."
Indeed, the relative position of the U.S. economy and markets on the world financial stage suggests that predictions that bond vigilantes are about to dump American debt -- often politically motivated -- are vastly overblown.
Even Housing Is Stirring
But investors should note that it's now a swell of strong economic news that may be putting pressure on Treasury prices. Indeed, the 10-year note sold off substantially in the wake of bullish data Thursday.
Initial jobless claims, for example, came in far better than expected this week, at their lowest level in more than two years, after either falling or holding steady for five of the last six weeks. and other signs of a increasing strength in the labor market have been mounting. The Chicago Purchasing Managers Index clocked its highest level in 22 years on Thursday and remained in expansionary territory for a 15th month. Even the housing market showed some signs of life, with pending home sales beating analysts' expectations.
As the economic recovery gains steam, ultrasafe investments like U.S. government bonds will become less attractive at their currently low yields. A rosier labor market, for example, may prompt the Fed to reduce the size of its second round of quantitative easing, which involves buying short-dated Treasuries.
Some signs of rising prices may revive the inflationary concerns that accompanied signs of a strengthening recovery in the spring. That could further pressure low-yielding Treasuries.
So, at least in the short run, those holding U.S. government bonds should be far more concerned about economic strength at home than creditors getting skittish abroad.