January 27, 2013 at 05:59 AM EST
The downside of the stock rally
Amid all the talk about Michelle Obama 's new hairstyle, Beyoncé 's lip-synching and the fiscal cliff in recent weeks, you might not have noticed that the stock market has rallied sharply. At about 13,900 as of Friday's close, the Dow Jones industrial average is just one really good day away from beating its all-time high of 14,100 set in October 2007, a few months after Apple introduced the first iPhone. The Standard & Poor's 500 is also on a tear; it's risen for eight consecutive days for the first time in nine years. The hitch is that when stocks rise, the value of U.S. Treasury and high-quality corporate bonds tends to fall, as money managers sell those securities to catch the equity rally. Sure enough, the yield on the benchmark 10-year government bond, which rises as its price falls, has jumped to 1.91% from 1.76% since the beginning of January. Some observers say the move could mark the beginning of the end for a rally in bonds that began in the early years of the Reagan administration, back when the benchmark government bond yielded over 15%. If this really is the turning point, needless to say there are major consequences for investors and the broader economy. First, the impact on investors: Ever since the crash of 2008, average folks have quite understandably taken their retirement money out of stocks and invested heavily in bonds. Over the past five years, mutual-fund investors have parked about $1 trillion in bond funds, according to the Investment Company Institute, and withdrawn more than $500 billion from equity funds. In other words, lots of individual investors bought lots of bonds just as the rally may have finally exhausted itself. Doesn't that have a depressing, familiar ring to it? A decline in bond prices—which is another way of saying a rise in interest rates—of course also has profound implications for the overall economy. Mortgage rates, for example, are tethered to the value of government bonds. So are corporate borrowing costs. Higher rates could halt the economic recovery dead in its tracks. That is precisely why the Federal Reserve under Chairman Ben Bernanke is doing everything in its power to keep interest rates low, including taking the extraordinary step of buying mortgages and other sorts of bonds on the open market. Certainly the decline in bond prices could be fleeting. Strategists at Charles Schwab observe that it's common for long-term bond prices to fall at the beginning of the year only to rise again as hopes of a strong economic recovery dim and investors return to the safety of bonds. "In 13 of the past 16 years, 10-year Treasury yields have peaked in the first half and subsequently declined later in the year," the Schwab analysts wrote in a recent report. What might be different this time? For one thing, stocks in the financial and transportation sectors are performing extremely well. The KBW Bank Index has risen 24% over the past six months, and the Dow Jones transportation index is up 18%, sharp improvements over a 5% decline and a 2% increase, respectively, for the indices over the year-earlier period. In other words, investors foresee a world with fewer defaults and more stuff being moved around. That is the foundation of a real economic recovery.
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