Will Bernanke’s head fake spark bond rally? Maybe so

The Federal Reserve Board’s surprising change of heart about reducing the pace of the five-year-long quantitative-easing program is seen by some advisers as creating new investment opportunities.

While it is difficult to argue against a positive outlook for risk assets such as stocks as long as U.S. monetary policy favors a low-interest-rate environment, there is also a solid argument for a near-term rally in bonds.

“We are very likely at this point to have another bond market rebound,” said Sam Jones, president of All Season Financial Advisors Inc.

“The future prospects for a long-term bond rally are not good, but you can probably make some money in bonds between now and the end of the year,” he added. “With tapering now off the table for the time being, bond money will be going back into the market over the next three to six months, and I think there are some good opportunities out there.”

A lot of investment outlooks are being revised following this week’s announcement by Fed Chairman Ben S. Bernanke that despite statements indicating the imminent beginning of tapering, the government will continue buying U.S. Treasury bonds and mortgage-backed securities at a pace of $85 billion per month.

The general consensus prior to the Fed announcement was that tapering would begin this month with monthly purchases reduced by between $10 billion and $15 billion, leading to a gradual end to quantitative easing within 12 months.

According to Mr. Bernanke, the economy is not yet strong enough to support tapering, which has led most market watchers to conclude that tapering is now unlikely at least until sometime next year.

“The markets on Wednesday were caught completely off guard by the Fed statement, and it was no different than an intelligence failure,” said Jonathan Lewis, chief investment strategist at Samson Capital Advisors.

Considering that the Fed’s criteria for tapering has always been to get inflation above 2% and unemployment below 6.5%, the market shouldn’t have been so surprised, he said.

“We didn’t have the criteria that the Fed was looking for, but the markets ignored that and pushed toward the conclusion of tapering,” Mr. Lewis said, explaining the snap-back rally in stocks, bonds and gold following the no-taper announcement.

Performance gap

Looking forward, and assuming that that won’t be an issue, he is firmly in the camp of strong support for bond prices.

“Many strategists were looking for stocks to have a good year, but nobody expected them to be up 20%,” Mr. Lewis said.

As stocks have rallied, total returns for bonds have fallen to the point that the gap between the performance of the two looks like a glaring misstep.

The total return for the 10-year Treasury this year is a decline of nearly 7%, and the 30-year Treasury has declined nearly 14%.

“It’s not surprising that stocks have done better than bonds, but how much better should that be?” Mr. Lewis said. “Right now, the relative dispersion between stocks and bonds is consistent with a turning point, and I’m not expecting stocks to suddenly fizzle out, but it’s not unreasonable that bonds will start performing better relative to stocks.”

The bond market offered a glimpse of its potential during a short rally after the Fed announcement, but as Mr. Lewis noted, bond yields have swung wildly since May, when tapering first looked like a possibility.

The yield on the 10-year Treasury in May hit a low of 1.6% and has since gained more than a full percentage point. If that yield falls from here by just 50 basis points, the total return on the 10-year over 12 months will be nearly 7%.

“There’s $2.6 trillion sitting in money markets that could be put to work,” Mr. Lewis said. “So far, bonds have not been the beneficiary of money moving off the sidelines, but that cash can’t stay there earning nothing forever.”

On the equity side, the outlook is more challenging, but still enticing, according to Tim Holland, a portfolio manager at Tamro Capital Partners LLC.

“In the near term, if one of the points of concern was restrictive monetary policy, well, that’s off the table now,” he said. “For stock pickers, you have to realize monetary policy will impact sentiment significantly, and that can be frustrating because, as fundamental investors, we have to look beyond that.”

Ultimately, the non-taper news should at least temporarily support equities — even if at a slower pace relative to bonds.

Longer-term, however, there is plenty of reason to worry, according to Jon Sundt, president and chief executive of Altegris Cos.

“We are recommending that investors participate in some kind of preservation-oriented strategies, because the real question is, can this rally continue when it becomes clear prices are not supported by earnings growth?” he said.

“There’s a lot of punch being served by the Fed, and no one knows when this party will end, because we’ve never done anything like this before. But sooner or later, we will have to deal with the hangover.”