How to Take Advantage of the Panic in the Bond Market

July 3rd, 2013

by Michael Lombardi

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Investors beware: the bond market is treading in very rough waters. The sell-off we have seen of U.S. bonds might just lead to more troubles ahead for the bond market. Just take a look at the chart below:

Thirty-year U.S. bonds look to be in a freefall. They have declined a little more than nine percent since the beginning of May — plunging from around $148.50 to below $135.00 now. As I have said before, the sell-off might just pick up speed as the losses of bond investors start to accumulate.

Keep in mind that long-term U.S. bonds are used as a benchmark on how other bonds (such as corporate bonds) will be priced. If the U.S. bonds decline in value, other types of bonds in the bond market follow suit.

Central banks, which normally buy U.S. bonds to protect their reserves, are selling them. Holdings of U.S. bonds held by the Federal Reserve fell by $32.4 billion to $2.93 trillion for the week ended June 26. That was the steepest reduction in their U.S. bonds holdings since August of 2007. And central banks have been reducing their U.S. bonds holdings for three out of the last four weeks. (Source: CNBC, June 28, 2013.)

That's not all. Individual bond investors are running for the door as well. According to the Investment Company Institute, the long-term bond mutual funds have been witnessing a continuous outflow. For the week ended on June 5, bond mutual funds had an outflow of $10.9 billion; for the week ended on June 12, the outflow was $13.4 billion; and for the week ended on June 19, bond investors pulled out $7.9 billion worth of bond mutual funds. (Source: Investment Company Institute, June 26, 2013.)

While some are calling the recent plunge in the bond market a buying opportunity, some major problems still persist.

Fitch Ratings recently provided a credit rating for the U.S. economy, keeping the rating at AAA — prime investment grade — but remaining pessimistic about the country's outlook. The credit rating firm reasoned that without cutting the budget deficit, the high national debt level will keep the country vulnerable. The firm said, "The outlook remains negative due to continuing uncertainty over the prospects for additional deficit-reduction measures necessary…over the medium to long term." (Source: "Fitch affirms U.S. AAA rating but outlook still negative," Reuters, June 28, 2013.)

Increasing national debt and the government's expenses are making the country's debt questionable, and the situation in U.S. bonds will be no different.

On top of all this, the Federal Reserve, which has provided the U.S. government with a line of credit by buying a significant amount of U.S. bonds, is becoming hesitant to buy any more. It has already hinted it will be slowing its U.S. bonds purchases later this year and will end its quantitative easing program by mid-2014.

If that does happen, a major buyer of U.S. bonds will be out of the market, and this departure — along with many other investors selling — will leave the bond market even more vulnerable.

I've been warning my readers about the risk of a bond market collapse for some time now. What does that mean for you? If the bond market continues to fall, it means interest rates are going up. Corporations that borrow heavily will see higher costs and lower profits.

One of my colleagues, George Leong, believes stocks will ultimately rise as investors leave the bond market and move into stocks. But from where I sit, I've never seen a stock market rise as interest rates rise. If you are invested in stocks, and I assume you are if you are reading Profit Confidential, my suggestion is to review each of your holdings to see how higher interest rates will affect them. I'd lower my exposure to companies sensitive to rate increases.

Michael's Personal Notes:

The Chinese economy is showing traits that you should be watching. The country is experiencing an economic slowdown unlike any it has ever seen before.

The HSBC Purchasing Managers' Index (PMI) for China has been contracting for two consecutive months. In June, the indicator, which provides an overview of manufacturing in the Chinese economy, registered at 48.2 — down from 49.2 in May. (Any reading below 50 on the PMI suggests a contraction in the manufacturing sector.)

New business from the global economy to China declined, and companies in China have slashed their workforces.

The country's new export orders in June fell at the fastest rate since March of 2009. (Source: Markit, July 1, 2013.)

In 2013, the Chinese economy is expected to grow at a pace slower than its historical growth rate. For example, Barclays PLC expects the gross domestic product (GDP) in the Chinese economy to grow at 7.4% this year. If this turns out to be the case, then this rate of GDP growth would be the slowest since 1990. (Source: Bloomberg, June 13, 2013.)

But that's not all. Other banks, like Morgan Stanley (NYSE/MS), have also lowered their expectations of growth in the Chinese economy as well. Morgan Stanley now expects the GDP of China to grow 7.6% in 2013, down from its original forecast of 8.2%.

The Chinese economy was able to show some improvement after the global crisis in 2009. The country's central bank reacted fast and flooded the financial system with liquidity. But the effects of all those efforts seem to be dissipating.

What many don't realize is that the Chinese economy can actually be considered an indicator of growth for the global economy.

Not only is China the second-largest economic hub in the global economy, but China also exports a significant amount of its products to the global economy. If the country experiences a GDP decline, it's because there isn't demand in the global economy.

An economic slowdown in China can have many consequences throughout the world. One of them is a toll on the growth of smaller nations. Consider this: in the first four months of this year, China consumed 12% of all exports from Thailand. If the economic troubles in China continue, then countries like Thailand — countries that depend on exports to the Chinese economy — will see their own GDPs decline. (Source: The Nation, June 26, 2013.)

A similar principle applies to the U.S. economy as well. China is one of our trading partners. If demand in the Chinese economy declines, our exports will be hurt as well — and this will have an impact on our GDP, as U.S.-based companies that depend on exports to China will suffer due to a persisting economic slowdown. Keeping a close eye on the Chinese economy can keep you ahead of the curve when it comes to investing — even in American companies.

What He Said:

"Recipe for Catastrophe: To me, the accelerated rate at which American consumers are spending, coupled with the drastic decline in the amount of their savings is a recipe for a financial catastrophe." Michael Lombardi in Profit Confidential, September 7, 2005. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.



Originally posted at Profit Confidential

© Michael Lombardi, MBA

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