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Market Commentary: What is the potential for a bear market?

Written by: Benjamin Bimson CIMA® / CIO, BCJ Financial Group

Secular bond bear markets are not something many current market practitioners have had to deal with. The last secular bond bear began just after WWII and ended in 1981. So why is the market so skittish about the potential of a bond bear market?

There are many reasons, and many of them are psychological. Plain and simple, the market hates change and are most stable without shocks to expectations. Uncharted territory can be frightening to market participants, leaving them to questions if what they have “known” is still going to work going forward.

The facts are that since the last time the yield curve was inverted (back in the summer of 2007), treasury bonds have been in a secular bull and cyclical bull market. That means they have been a profitable investment.

The last cyclical bond bear was between 2003 and summer 2007. It’s too early to say whether we are in a new secular or cyclical bond bear market. It is always harder to discern a secular market versus cyclical market since secular market cycles are so long, span multiple economic cycles, and need significant time to develop as trends.

When I look at the data, the cyclical trend has been broken beyond two standard deviations from the average. That is usually something that grabs the market’s attention because it is unusual and happens less than 2% of the time.

Looking at the 10-year treasury, historically we can see a few times where there were breakouts above the second standard deviation with a rise in yield. It’s not necessarily the end of a series, but can give quite a spook.

Last 20 years of the treasury yields, green lines mark the cyclical bull markets and red cyclical bears. One interesting fact is that bond bear markets often precede economic recessions. Chart Source: BCJ Financial Group

Bond cycles can be long and secular bond cycles can be very long, often spanning decades and multiple economic cycles. This is one of the big reasons that they can be helpful to watch.

Another reason bonds struggle is that bear markets and rising interest rates correlate with Fed rate hike cycles. Clearly the Fed is in a hiking cycle and the current trajectory is for 3 and possibly 4 rate hikes in 2018.

According to CME Group, normal rates are viewed by FOMC participants to be achieved by 2020, somewhere around 3%, which is more than twice the current Fed rate at 1.25%.

CME Group’s chart shows consensus estimates in blue dots. Chart Source: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

The bond market is anticipatory in nature. That means as bond investors become convinced that certain rate assumptions are realistic, bond prices move inversely to their yield views. Thus, when bond yields rise, bond prices fall.

Bonds typically do not work on the same cycle as the economy and stocks due to their sensitivity to rates. When economies are expanding quickly, the Fed raises rates to keep a lid on inflation and an overheating economy. This is notoriously a difficult task and the Fed often overshoots, causing the economy to respond with recessions. With this in mind, bonds can be a good bellwether.

Whether or not we will look back on early 2018 as the end of the bond bull market, is something we cannot possibly know today. Evidence is mounting, but extreme pessimism can lead to wrong decisions if it is too early.

The entire market is focused on this because it is going to happen sooner or later and may have even started already. Bond investors typically make significantly less in a bond bear market, but returns are often available in stocks during that period. Volatility is also a normal byproduct of these inflection points and more volatility in both bonds and stocks is probable.

As these trends develop, we will be presented with more and more evidence that will be increasingly useful in strategy decisions. For now, it is the hour of the guru predictions. We will either develop a new bond bear market, or yields will drop proving this was a potential bond bear trap.

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Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory Service offered through BCJ Capital Management. World Equity Group, Inc. and BCJ Capital Management are independently owned and operated. Investment advisory services are offered through BCJ Capital Management, an SEC registered investment adviser. BCJ Capital Management is a (SEC) registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. BCJ FG 18-34

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