Prices for 7- to 10-year Treasuries fall--if that's a trend expect money to start flowing back into stocks from bonds

11/19/2010 12:38 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

For most of 2010 Treasury bonds have been a very good investment. Sure, they haven’t paid much in interest but with yields falling, Treasury bond prices have been climbing. And so the gain on the iShares Barclay 7-10 Year Treasury ETF, which tracks the price of seven to ten year Treasuries, was 12.7% from January 4, 2010 through October 11. Plus interest.

Sure beats the 2.9% gain on the Standard & Poor’s 500 Stock Index for the same period.

No wonder money has flowed out of stock mutual funds and into bond mutual funds for most of the year. And out of equities and into bonds in general.

But you’ll notice that I stopped my performance numbers more than a month ago. Since then the trend in medium-term Treasuries has been down. And that trend has accelerated recently. From its peak on October 11, 2010 at $100.08 the Barclay Treasury ETF has dropped to $96.92 on November 18. That’s a drop of 3.5% in a little more than a month.

That kind of performance, obviously, makes Treasuries a much less attractive investment. A decline of a month in duration isn’t enough to change opinion among bondholders. It’s simply not long enough. But if that downward move ascends to the level of a trend in the minds of investors, then I think we’d see some of the money that flowed into bonds and bond mutual funds start to flow into stocks and stock mutual funds.

What might delay the transition from event to trend is that the decline in bond prices is so counter-intuitive. (Fancy talking’ for It don’t make no sense.)  If the Fed is buying Treasuries, and particularly targeting these maturities in an effort to get interest rates down, shouldn’t the price of these bonds be going up?

Well, yes, unless bond investors are convinced that the Federal Reserve’s new program of quantitative easing is going to work. If the Fed’s efforts are actually going to be successful and stimulate growth in the U.S. economy, then growth and inflation will both pick up and bond prices should indeed head downward. That’s the logic that has driven up yields on 30-year Treasuries in the weeks after the Fed announced QE2 in early November. And the logic that has Paul McCulley, a portfolio manager at PIMCO (Pacific Investment Management) telling Bloomberg that “The grand super secular bull market is essentially over.”

That’s almost certainly right—sooner or later. But in the short run the conclusion isn’t inevitable. If the bond market decides that the Fed’s solution will work, then interest rates won’t go down and QE2 won’t deliver the desired stimulus.

That would leave the heavy lifting in the U.S. economy to the wealth effect as a climbing stock market lifts confidence among consumers and CEOs.

And those who think that the Fed’s real game is to engineer a stock market rally as a way to get the economy growing again would have turned out not to be cynical but correct.

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